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Broken curves: are misguided inflation measures leading to policy mistakes?

John Pattullo | Janus Henderson Investors
John Pattullo

John Pattullo

Co-Head of Global Bonds | Portfolio Manager

15 Aug 2018
Once, a useful gauge for inflationary pressures in an economy and used by central banks in setting policy, the Phillips curve has broken — it is flawed for the world that we live in today. John Pattullo explores the reasons behind the malfunction and explains why he believes central banks should now avoid relying on the curve in setting policy.

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 has broken — it is flawed for the world that we live in today.

Economics 101: explaining the Phillips curve
First discovered by the London School of Economics (LSE) 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 (NAIRU1) 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 labour costs, employers would then seek to pass on the cost increases to consumers via higher prices (leading to escalating inflation).

The Phillips curve has been a useful tool in the analysis of macroeconomic policy and central bankers have been able to exploit the trade-off between unemployment and inflation in setting policy — a little more unemployment means a little less inflation and vice versa.

Figure 1 shows an example of a Phillips curve plotted for different periods in history. Here is a plot of wage inflation versus the output gap (another measure of slack2 in the economy). A positive output gap is associated with low unemployment (below NAIRU), while a negative output gap implies high unemployment.

Figure 1: Long-run UK Phillips curve

[caption id="attachment_63100" align="alignnone" width="680"]Broken curves: are misguided inflation measures leading to policy mistakes? | Janus Henderson Investors Source:  Thomas and Dimsdale (2017) and Janus Henderson calculations. This is a modified version of a chart in Haldane (2017). Note:      Output gap estimated using a HP-filter technique. Wage series used is a composite based on English and Great Britain estimates.[/caption]

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 (it was possible to have different inflation rates for a given unemployment rate), prompting various new economic theories, such as there being no single Phillips curve, but a series of short-run curves with a steep long-run curve centred on NAIRU. In more recent years, studies show that 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 that 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 (GFC), inflation has remained stubbornly low, not just in the UK, but also in the US and Japan.

Searching for clues on low inflation
Many theories have been proposed to explain the lack of inflation around the globe. The best explanations were summed up by Andrew Haldane, the Chief Economist of the Bank of England, in a recent speech in Bradford in June 20173. Stating that wages have been surprisingly weak for most of the period post the GFC against the backdrop of a booming UK job market, Haldane outlined a number of causes leading to weak wage inflation.

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 GFC on slack in the labour market (ie, the number of skilled people remaining unemployed or doing the wrong job). But others are structural causes (basic shifts or changes in the way an economy or market works), such as innovations in technology and globalisation that have weakened the bargaining power of the workers.

Longer term factors also creating low inflation
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 precariat4. 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. The precariat are estimated to represent around 40% of the adult population in Australia, Greece, Italy, Korea, Japan, Spain and Sweden, while the biggest precariat class is in China.

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: company behaviour compounding the situation
The pass-through mechanism of wage inflation feeding into goods and services (consumer price index or CPI) 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 burden 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 reductions, 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 that the curve is flawed. Some are conveniently reducing their expected level of NAIRU 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 (Fed) and its Chair, Janet Yellen (a ‘wage’ economist), also certainly continue to believe in the curve. Although the Fed adjusted its language at the latest meeting in July, acknowledging that both core and headline inflation are “running below 2 percent”, it still views the lack of inflation as transitory, and/or due to idiosyncratic reasons, expecting inflation to return to target in a year’s time. As an analyst recently outlined, the Fed’s desired inflation and growth metrics seem to have shifted somewhat from ‘cautiously optimistic’ to ‘fearfully hopeful’5.

Given that the Phillips curve remains broken, could the Fed’s next rate hike prove to be a policy mistake? 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 stock market, rather than the narrow CPI?

  1. NAIRU: non-accelerating inflation rate of unemployment; this is the level of unemployment within an economy at which inflation is stable. In effect, the rate represents the equilibrium between the state of the economy and the labour market.
  2. Slack: in simple terms is the amount of unused capacity in the economy, such as the number of empty desks in an office or machinery left unused in a factory. More formally, slack is defined as the difference between an economy's productive capacity — the amount of goods and services that could be produced if all labour and capital were fully and efficiently employed — and the actual level of economic output.
  3. Work, Wages and Monetary Policy. Speech given by Andrew G Haldane; Chief Economist, Bank of England. National Science and Media Museum, Bradford. 20 June 2017. 
  4. Working-Class Perspectives: The Precariat: The New Dangerous Class. Post by Guy Standing, Professor of Economics, SOAS, University of London, 27 October 2014.
  5. The Bear Traps Report: The Obvious and the Unexpected, Larry McDonald, 25 July 2017.

Important information

Please read the following important information regarding funds related to this article.

These are the views of the author at the time of publication and may differ from the views of other individuals/teams at Janus Henderson Investors. Any securities, funds, sectors and indices mentioned within this article do not constitute or form part of any offer or solicitation to buy or sell them.

 

Past performance does not predict future returns. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested.

 

The information in this article does not qualify as an investment recommendation.

 

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John Pattullo

John Pattullo

Co-Head of Global Bonds | Portfolio Manager

15 Aug 2018

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John Pattullo

John Pattullo

Co-Head of Global Bonds | Portfolio Manager

John Pattullo is Co-Head of Global Bonds at Janus Henderson Investors. He manages and co-manages a range of global bond strategies and funds meeting different client needs globally. John joined Henderson in 1997 as a trainee manager in corporate bonds and was head of the Strategic Fixed Income Team from 2009 until 2015 when he became Co-Head with Jenna Barnard. Prior to Henderson, he spent four years as a chartered accountant at PricewaterhouseCoopers.

John has an MA (Hons) in economics from the University of St Andrews. He is a member of the Institute of Chartered Accountants of Scotland (CA) and an associate member of the Society of Investment Professionals (ASIP). He has 30 years of financial industry experience.

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