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John Pattullo: Searching for fresh clues on low inflation

The go-to gauge for inflationary pressures in an economy is broken and the sooner central bankers accept that, the better

The Phillips curves in the UK and the US are as flat as a pancake. Once a useful gauge for inflationary pressures in an economy, the curve is broken. It is flawed for the world we live in today.

What is the Phillips curve?

First discovered by British economist A W Phillips in 1958, the curve represents the long‑term relationship between unemployment and inflation in an economy. The curve, an inverse but stable relationship between wage inflation and unemployment, implies that changes in the level of unemployment would have direct and predictable effects on wage inflation.

In simple terms, increasing demand for labour in an economy would result in a fall in the unemployment rate to a level (non‑accelerating inflation rate of unemployment) beyond which unemployment may go lower but inflation begins to rise.

This would force firms to compete for workers by raising wages. Faced with rising costs of wages, the employers would then seek to pass on the cost increases to consumers via higher prices, leading to escalating inflation.

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The Phillips curve has been a useful tool in the analysis of macro policy, and central bankers have been able to exploit the trade‑off between unemployment and inflation in setting policy.

A break in the relationship

The relationship between unemployment and inflation as implied by the Phillips curve was stable and strong both in the post‑industrial revolution (1860-1950) and the post‑war period (1950-70).

However, the curve began to break down in the mid 1970s, prompting various new economic theories, such as there being no single Phillips curve but a series of short-run curves with a long-run curve that exists at the natural rate of employment. In more recent years, studies show the trade-off between the two elements of the curve has disappeared.

In the UK, between 1993 and 2008, unemployment fell to record lows but inflation did not rise as predicted by the curve. The reason for this was given as successful supply-side policies. Another study of data between 1993 and 2016, reveals the relationship has completely disappeared, with both inflation and unemployment falling from 2011.

The main cause of the breakdown is disappearing inflation. While the number of unemployed has been falling since the global financial crisis, inflation has remained stubbornly low, not just in the UK but also in the US and Japan.

Many theories have been proposed to explain the lack of inflation around the globe. The best explanations were summed up by Bank of England chief economist Andrew Haldane in a speech in June. Stating that wages have been surprisingly weak for most of the period post-financial crisis against the backdrop of a booming UK job market, Haldane outlined a number of causes.

Some could be short and transitory, such as the impact of actual – as well as expectations of – low inflation around the world. Some could be longer term, such as the impact of the financial crisis on slack in the labour market (the number of skilled people remaining unemployed or doing the wrong job). But others are structural causes, such as innovations in technology and globalisation that have weakened the bargaining power of the workers.

Our working environment and relationship with employers is changing rapidly. There are increasing numbers of self-employed, flexible and part‑time workers, as well as zero hour contractors within the workforce — a trend that is set to stay. There is a new name for this class of workers: the Precariat.

Defined in many ways, the instability and insecurity of their jobs and the lack of benefits such as work pensions and paid holidays are chief among the characteristics of this rapidly expanding group of people.

Thus, there is less structure to work, with jobs becoming more casual and informal compared with the past. Work is now more “divisible” than in the past. More workers are paid by the hour, wage bargaining is more at the level of the individual as opposed to the unionised collective bargaining of the past and there is evidence of a “discount” to wages associated with individual bargaining.

A new reality

The pass‑through mechanism of wage inflation feeding into goods inflation remains broken for the time being.

While wage bargaining power may be declining, legislation could bring about wage pressures. In the UK, following the last government’s pledge to increase the national living wage by 2020, employers began to look for ways to offset the rising cost, namely by cost‑cutting strategies, given the limited options in passing on the price increases.

As an example, Costa Coffee and Premier Inn owner Whitbread, which employs over 15,000 lower wage staff, announced a £150m cost‑cutting plan including job cuts, to offset the cost of the minimum wage pay rise. As long as companies continue to absorb the inflationary impacts of wages, inflation will remain dormant.

Playing with numbers

Central banks are finding it difficult to let go of the Phillips curve, rather than admitting it is flawed. Some are conveniently reducing their expected level of NAIRU (the level of unemployment that does not cause inflation to rise) to vindicate their view of the curve.

The Bank of England, for example, lowered its view on NAIRU in early 2017, and members of the European Central Bank have recently voiced concerns that flexible working may lower NAIRU.

The US Federal Reserve and its Chair Janet Yellen (a ‘wage’ economist), also continue to believe in the curve. Even though at the latest meeting in July, the Fed adjusted its language, acknowledging both core and headline inflation are “running below 2 per cent”, it still views the lack of inflation as transitory and/or due to idiosyncratic reasons. It expects inflation to return to target in a year’s time.

Given the Phillips curve remains broken, could the Fed’s next rate hike prove to be a policy mistake? But if they recognise the breakdown, the reduced need to fight inflation will ultimately mean less chance of higher bond yields.

Perhaps central bankers should be targeting broader measures of inflation, such as house prices and the stockmarket, rather than the narrow CPI?

John Pattullo is co-head of strategic fixed income at Janus Henderson Investors


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