Is the Phillips curve breaking down? Tight labor markets have historically tended to place upward pressure on wages and inflation. And the Phillips curve, a theory embodying the inverse relationship between inflation and unemployment, has been the cornerstone of modern monetary policy.
Yet U.S. CPI and wage inflation remain modest today, despite a nearly eight-year U.S. economic expansion and an unemployment rate that has already dropped below the Federal Reserve’s estimated “natural rate of unemployment” (the “equilibrium” long-run level of unemployment, often used interchangeably with the “non-accelerating inflation rate of unemployment,” or NAIRU). This casts doubt on the importance of labor market slack as a driver of inflation.
It’s important to note that future realized inflation depends on both historically realized inflation and inflation expectations. Phillips curve believers – unable to explain the low inflation rate in the current setting – might argue that this is because U.S. inflation expectations are very well anchored. Indeed, studies have documented that the weight of long-term expectations in the Phillips curve has risen steadily since the mid-1980s, while the slope of the Phillips curve has substantially declined, and the curve today could be flat.1
Make no mistake, a flat Phillips curve would be a welcome development for the Fed, if inflation were on target. The reason is fairly straightforward: If people expect long-term inflation to be stable, wages won’t react as much to near-term changes in labor market slack. In this scenario, if a shock were to push inflation up, then anchored expectations would push it back down without the need for monetary tightening (and vice versa).2
But here’s the hitch: Even though U.S. inflation expectations are supposed to be very well anchored, no one can tell where.
An elusive anchor
So what are some of the possibilities?
Looking at core personal consumption expenditure (PCE) inflation (see Figure 1), the Fed’s preferred benchmark, one could speculate that the U.S. is well anchored at 1.5% – not the 2% Fed target – just as Japan and the eurozone appear solidly anchored below target at 0% and 1%, respectively. Here the Fed usually points to professional surveys of inflation expectations, which tend to show somewhat higher values. Yet professional forecasters’ longer-term expectations have exceeded realized inflation almost 70% of the time since the early 1990s (when records began).3
Similarly, the Fed has been systematically discounting low market-based inflation expectations, attributing them to either reduced liquidity in the Treasury Inflation-Protected Securities (TIPS) market or to changes in the inflation risk premium. We disagree with the Fed here. As we’ve pointed out in the past, the distribution of potential inflation outcomes – and market perceptions of the likelihood of downside or upside misses – is at least as relevant as the mode, if not more. The latest research from the European Central Bank (ECB) suggests that a negative inflation risk premium is associated with strong deflation risk, rather than low inflation uncertainty.4 In essence, the market assigns a higher probability to the Fed’s missing to the downside.
To further complicate matters, prolonged deviation