Hussman Dismantles the Phillips Curve

| April 4, 2011

When it comes to the financial markets, there is a great deal of conventional wisdom that, upon closer scrutiny, is anything but wise. You have probably heard the catch phrases. “Don’t fight the fed,” “Falling interest rates always support stock prices,” and “Recessions are always preceded by an inverted yield curve” are but a few of the more popular myths that are quoted by many mainstream analysts. Then there is the Phillips Curve, which is said to indicate that an environment of high unemployment is always associated with low inflation, suggesting that government fiscal and monetary policies can target employment growth without worrying about any inflationary consequences. Unfortunately, the data clearly do not support these assertions, and fund manager John Hussman addressed the failings of the Phillips Curve argument in his latest weekly commentary.

The chart below shows the historical record, since 1947, plotting the U.S. unemployment rate against the subsequent rate of CPI inflation over the following 2-year period. The correlation is essentially zero (techically, it’s slightly positive, implying no “tradeoff” at all in historical data). I should also note that the same lack of correlation holds between unemployment and inflation measured over the previous 1-2 year period.


As it happens, economists have been well aware of this lack of correlation for decades, but because of the simple intellectual appeal of an inflation-unemployment tradeoff, they have gone to great lengths to try to make the relationship work. The most prominent version of this is the “expectations augmented” Phillips Curve, which looks at the graph above as a whole set of “nested” Phillips Curves (like indifference curves in consumer theory), where each curve is set at a different level based on the level of expected inflation. In this view, unexpected inflation moves you along a given Phillips Curve, while expected inflation shifts you to a different curve. While this version of the theory is popular among economists because it gives them a modeling “environment” in which to teach the importance of expectations and so forth, the fact remains even the expectations-augmented version has only a weak relationship to actual economic data.

We can get to the heart of the Phillips Curve by asking one crucial question: What is the difference between Britain in the period from 1850-1950, and the United States in the post-war period? The answer is simple. During most of the period that Phillips studied, Britain was on the gold standard. As a result, the general price level was actually very stable, with very little general price inflation at all. So when Phillips observed wage inflation, he was actually observing real wage inflation as well. When unemployment was low and available labor was scarce, workers were able to command a greater amount of real goods and services in return for their work. In contrast, when unemployment was high and available labor was plentiful, workers found that their standard of living typically did not rise quickly because their services were not in sufficient demand.

Phillips demonstrated a principle that is well-known to every economist: very simply, when a useful resource becomes scarce, its price tends to increase relative to the prices of other goods and services. That finding doesn’t need all sorts of intellectual contortions or modeling tricks to make it “work,” because it is one of the most basic laws of economics. The true Phillips Curve, then, is a relationship between unemployment and real wages. When workers are scarce, wages tend to rise faster than the general price level. When workers are plentiful, wages tend to rise slower than the general price level. If we look at U.S. data in this way, we find precisely what A.W. Phillips found in British data. The following chart plots the U.S. unemployment rate versus the annual inflation in real wages (average hourly earnings deflated by the GDP price deflator) over the subsequent 2-year period.



The importance of the true Phillips Curve should not be underestimated. First, there is in fact no strong “tradeoff” between unemployment and general price inflation, and almost certainly not an exploitable one. The Phillips Curve is essentially a statement that lower unemployment is associated with higher inflation in real wages. The strategy of accepting higher inflation in hopes of achieving lower unemployment (which is the basis of Bernanke’s policy efforts) not only drops the phrase “real wages” but reverses the direction of cause and effect.

The Phillips Curve argument is another excellent example of a mainstream notion that has no underlying substantive merit. The analysts who present these sound bites of purported market wisdom are hoping that viewers will accept them at face value and not perform any further due diligence, which is yet another reason to develop self-reliance as an investor or trader. Never take the validity of market “wisdom” for granted, and take the time to research such claims before affording them any of your trust. In general, the less you need to rely on market analysts like us, the better off you will be.

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Category: Commentary, Market Update


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