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A tale of two Phillips curves

Created:

16 November 2009

Written by:

Chris Dillow

Sorry to dredge up bad memories, but do you remember Norman Lamont? He famously said that unemployment is a "price worth paying" to get inflation down. If this is so, then today's figures, showing unemployment close to an 11-year high, have a silver lining - they should reduce inflation. Sadly, though, recent history suggests they might not do so.

The simplest way to see this is to look at the Phillips curve, named after Bill Phillips, the New Zealand economist who first discussed it in the 1950s. This says there should be an inverse relationship between unemployment and inflation. High unemployment should lead to lower inflation, in part because it forces wage growth down.

However, there has recently been no such relationship. My chart shows this. It plots unemployment against CPI inflation (minus energy and unprocessed foods) in the following 12 months; I'm using the period since May 1997, when the Bank of England was made independent. As you can see, the points are all over the place. Yes, the line of best fit slopes down, as it should. But the points are scattered so much as to suggest the line is meaningless.

This implies that high unemployment, in itself, might not lead to lower inflation. The Phillips curve doesn't apply.

But this is not a universal fact. My second chart shows the Phillips curve over the same period for the US, again using CPI inflation excluding food and energy.

Here you can clearly see a negative relationship. Unemployment alone predicts over half the variation in inflation over the following 12 months.

If this is any guide, then the fact that unemployment is at a 26-year high of 10.2 per cent points to inflation there falling.

But why is there such a huge difference between the UK's and US's Phillips curves?

One reason is that the UK, unlike the US, is a small open economy. Our inflation is therefore more affected by variations in import prices and the exchange rate. So if, say, high unemployment here causes sterling to fall, import prices will rise, offsetting the disinflationary effect of lower wage growth. Because the US imports less relative to its economy, exchange rate changes matter less for its inflation.

Now, you might think this doesn't much matter for where UK inflation is heading - because if US inflation falls, so too should ours. This is the benefit of globalization.

Not necessarily. Since 1997 the correlation between UK and US "core" inflation has actually been negative. For example, US inflation fell to zero in 2000 whilst UK inflation rose a little.

So, not only is high UK unemployment not a strong reason to expect UK inflation to fall, nor is high US unemployment.

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