What does the Phillips curve tell us about the economy?

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We got another labor market indicator on Wednesday ahead of Friday’s jobs report. According to ADP, the private sector added 152,000 jobs in May. That’s fewer than were added in April, so a bit of a slowdown.

As a reminder, maximizing employment is part of the Federal Reserve’s dual mandate. The other part is keeping prices stable. And there’s this idea in economics that the two things — unemployment and price growth, inflation — are linked. It’s what’s known as the Phillips curve.

Economist A.W. Phillips came up with what’s known as “the Phillips curve” in 1958. It says that low unemployment is linked to high inflation. 

“When unemployment is low, wage increases have to be larger,” said Ann Owen, a professor of economics at Hamilton College.

Companies are competing for fewer available workers, so they up their wages to bring them in. But that costs money. So, she said, “they need to be able to pass those higher costs along to consumers in the form of higher prices.”

In other words, inflation. And if that’s the case, it’s kind of a bummer, right? Because it means in order to slow inflation, more people need to be out of work.

“That’s why they call economists the dismal scientists, right? Because we’re kind of bumming people out all the time telling you about the trade offs,” said Owen.

Monetary policymakers can use the Phillips curve, says Allison Luedtke, professor of economics at St. Olaf College.

“If you’re like, ‘I’m really going after unemployment.’ Good. But be aware, there might be the cost of higher inflation,” said Luedtke.

Except, the Phillips curve relationship sometimes breaks down. For example, even when unemployment is high and there are lots of workers available, employers don’t generally cut wages. So, inflation won’t be zero. It also doesn’t take into account other factors that also contribute to inflation. 

“It’s a simple tool. It can’t do everything; we need more tools,” said Claudia Sahm, chief economist at New Century Advisors, and who used to work for the Fed. 

She points out one of the factors that’s led to inflation over the past few years is supply chain disruption. 

“The Phillips curve is not useful for that. It’s just not in the concept of it. So it really came down to a debate of what’s causing inflation,” said said Sahm.

And lately, it’s been difficult to use the Phillips curve to make predictions.

“The stability of the Phillips curve has not been great for at least 20 years,” said economist Ann Owen.

There’s no magic button to control inflation, as we’ve seen. Instead, Owen says, it’s best to think of the Phillips curve as a framework to understand the economy.

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