The Phillips Curve

Earlier this year, I chanced upon an article in Bloomberg that mentioned the Phillips Curve, and I thought this would be the perfect opportunity to talk about how the Curve relates inflation and unemployment. Basically, the gist of the article is this: in January of this year, the current Fed chairwoman, Janet Yellen, expected a pickup in inflation as the economy improves and hiring picks up, potentially signaling that the Fed may raise interest rates in the future. Critics charge that future inflation will be lower than Fed expectations, with former Treasury Secretary Larry Summers warning that the Fed may cause deflation – an environment with falling prices but weak demand – should the Fed raise interest rates too soon. Mr. Summers also indicated that the Fed should not base its interest-rate decision on the Phillips Curve.

So, what’s the Phillips Curve?

In our introduction to fiscal policy, monetary policy, and inflation, we mentioned that inflation is interrelated with the business cycle and unemployment, since inflation also influences the fluctuation of GDP. The Phillips Curve is a theory that explicitly links inflation and unemployment.

It works like this: the curve slopes downward as unemployment increases, with inflation decreasing.

Sample chart of the Phillips Curve.

Sample chart of the Phillips Curve.

If you go the other direction, as unemployment decreases, inflation increases. This plays into what we have learned before, with a stronger economy featuring lower unemployment and higher inflation, and a weaker economy featuring higher unemployment and lower inflation.

Mr. Summers’ contention is that “the Phillips Curve is a constantly changing, ephemeral relationship that does not provide a confident basis for a tightening [ie, raising interest rates].” Some would argue against this statement, and this situation goes to show how Economics is not at all an exact science and is open to opinion and debate.

"Ephemeral" (ink and watercolor sketch, 13.8x18.7 cm)

“Ephemeral” (ink and watercolor sketch, 13.8×18.7 cm)

 

Ramon Rodrigo Cuenca, CFA

Equities Analyst
Art and Finance
Assistant: Mack Agbayani

Sources/Links:

CFA Curriculum Level I, 2009, volume 2, pp. 392-396

Investopedia definition of deflation

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