As governments struggle to fight inflation, central bankers have reverted to old certainties. Interest rates are rising, with the US Federal Reserve predicting three years of rising unemployment as a result.
The strategy is familiar: unemployment must rise for inflation to fall. The basic model underlying this central axiom of central banks is the Phillips curve, which postulates an inverse relationship between unemployment and rising prices. When unemployment is low, it is believed, workers have the bargaining power to demand higher wages, driving up costs for businesses, which then pass them on to consumers through higher prices. .
Until a few months ago, however, the Phillips curve seemed to be on its deathbed. Since the 1990s, inflation has been surprisingly unrelated to unemployment. This conundrum was heightened in the decade following the global financial crisis, when skyrocketing unemployment combined with persistently below-target inflation.
In 2017, former Federal Reserve Governor Daniel Tarullo went so far as to say that “we do not, at the present time, have a theory of the dynamics of inflation that works well enough to be useful for real-time monetary policy-making activities”. .
Is the Phillips curve back in business?
Central bankers may have gone back to their old ways in the face of the current inflationary crisis, but the questions raised about the Phillips curve over the past decade are more important than ever.
These questions are the subject of a recent paper by two US Federal Reserve economists, who have been trying to uncover the reasons for the disappearance of the Phillips curve since the 1980s. What they discovered is that the model lacked a crucial variable: unions.
When unions are weaker, the researchers say, so is the relationship between unemployment and inflation. The reasoning is quite simple: low unemployment increases the bargaining power of workers, but it is the unions that realize this bargaining power in the form of wage agreements.
If unions and business are closely matched in their bargaining power, the paper suggests, inflation will ensue. Firms facing strong unions but weak market competition can maintain their margins by simply raising prices. Unions react in kind by demanding wage increases to compensate for inflation, and the cycle continues.
Before Ronald Reagan and Margaret Thatcher came to power in the US and UK respectively, researchers show that trade unions and business were indeed nearly equal on both sides of the Atlantic, giving rise to exactly this type of wage-price spiral. During and after the 1980s, however, anti-union legislation and the rise of globalization combined to shift power overwhelmingly to business.
Based on their model, the researchers show that such a decline in union power could, in the absence of higher interest rates, reduce inflation volatility by 87%. Based on this decline in workers’ bargaining power, the researchers also found they could explain a number of other secular trends in advanced economies: rising inequality, rising profit share, falling investment and increase in market capitalization.
The widely observed fall in the natural rate of unemployment, a rate compatible with stable inflation, is also well explained. Essentially, employing workers becomes more profitable because firms retain a higher share of each worker’s output.
Central banks have not beaten inflation
As far as prices are concerned, the implication is that central banks took too much credit for the defeat of inflation in the 1980s. business owners.
Today’s inflation could hardly be more different. Trade unions may be on the rise across the Atlantic, but they remain a shadow of themselves. Low unemployment should not allow British workers to negotiate a 3.4% real wage cut, nor allow American workers to fight the fastest decline in real wages in four decades.
Nominal wages in some sectors have increased significantly, but overall price increases in the UK remain largely concentrated in areas exposed to the current energy crisis (namely housing and transport). In the United States, the picture is more mixed, with the generous tax support provided during the Covid-19 pandemic likely playing a larger role.
Either way, the current bout of inflation is a sign that economies are making a one-time readjustment – whether to a reduced supply of energy or a greater supply of liquidity. The erosion of real wages is a sign that today’s workers, unlike their parents, have little strength to defend their corner as this adjustment proceeds.