On Wednesday, during a high-profile exchange with progressive firebrand Alexandria Ocasio-Cortez, Jerome Powell declared the link between unemployment and inflation nearly dead.
And I mean that literally. “The connection between slack in the economy – the level of unemployment and inflation – was very strong if you go back 50 years and it’s gotten weaker and weaker and weaker to the point where it’s a faint heartbeat”, Powell said, during testimony before the House Financial Services committee.
Those comments were part and parcel of the Fed chair’s efforts to underscore that the factors weighing on inflation might prove to be more persistent than the Fed imagined. In other words, Powell tried to walk back his infamous “transitory” remarks from the May press conference.
The irony proved to be that just 24 hours after his prepared remarks to the House crossed the wires, the MoM read on core CPI for June printed the hottest since January of 2018. Obviously, that’s not going to derail the Fed at the July meeting (they’re pot committed), but it was funny.
The exchange between Powell and AOC showed that the “death” of the Phillips curve is by now a reasonably well-understand concept. I wouldn’t go so far as to call it “mainstream” and it’s true that someone like Ocasio-Cortez would go out of her way to understand it given that if the relationship between unemployment and inflation no longer exists, there are important implications for the types of policies progressives need to adopt in order to fund hugely expensive agenda items. That said, the notion that the Phillips curve no longer applies is now water cooler fodder for anyone who keeps apprised of markets. That is, it’s just about as “mainstream” as it’s going to get.
But what if we’ve all left it for dead at just the wrong time? What if the Phillips curve, like the villain at the end of a slasher flick, isn’t really dead and is poised to snap back to life just when we’ve all let down our guards?
In June of 2018, in a characteristically brilliant exposition, Deutsche Bank’s Aleksandar Kocic described the Phillips curve as follows:
Through the last four cycles, Phillips curve has asserted its importance in an unorthodox way and, as such, attained a special status; it inhabits a space different from other macroeconomic frameworks and metrics. In each cycle, it falls apart, but after every annihilation, it re-composes itself and continues to play an important role. It appears “indestructible”, but not in a conventional way, more like a survivor of one’s own death. Phillips curve functions like an organ without a body, an equivalent of Cheshire cat’s smile (in Alice in Wonderland) that persists alone, even when the cat’s body is no longer present.
This time is no different in our view. The figure shows the Philips curve through several cycles starting in mid-1980s. Each cycle has a different color which implicitly marks their beginning and end. The first thing one observes is that this is more of a “spaghetti” then a curve. The main reason is that it captures different cycles – a testimony to its falling apart and recomposing itself after each.
Again, that was 13 months ago, and what you want to focus on in the graph are the vertical lines at the end of recoveries. As Kocic went on to write at the time, “in the past, this stage always exhibited a dramatic (practically straight line) rise in wages in response to infinitesimal improvements in economic activity”.
In a note dated Friday, Kocic picks back up on this in light of recent events.
“For a long time, the Phillips curve was considered ‘biologically’ dead but symbolically alive; despite its persistent flatness between 2009 and 2016, its significance was never completely dismissed”, he writes, on the way to reminding you that the curve’s assumed awakening and subsequent steepening “was used as the main tool for justifying persistent Fed hikes post 2016”.
Now, we’re faced with the opposite scenario. “In a strange twist of fate, the Phillips curve now is fully ‘alive’, doing what it is supposed to be doing, only to be half-ignored”, Kocic says, illustrating the point with the figure below which just shows the Phillips curve for the current cycle.
An alarmist read would be to simply say that the Fed is now so determined to cut rates to placate markets and pacify Donald Trump, that policymakers are now data-independent – committed to cutting rates come hell or high inflation.
But that’s too strong. Recapping points he made in subsequent notes last year (i.e., in research that followed the original “Cheshire cat” piece), Kocic reminds you on Friday that “although the first signs of steepening did appear alarming, the slope (roughly 60 degrees) has remained steady for almost two years without signs of getting more severe, indicating no urgency for rate hikes”.
He then reiterates the point from the excerpted passage above. “In the previous recovery cycles, once the full employment is reached, the steepening of the Phillips curve reaches 90 degrees (becomes vertical) – infinitesimal improvements in the labor market caused singular responses in wages”, he says.
Of course, another takeaway from the visual above is that there really is no case for rate cuts right now in any traditional or historical context. After elaborating on the labeled quadrants in the chart, Kocic simply states that “irrespective of everything else, rate cuts do not belong anywhere on the left side of NAIRU; Phillips curve or no Phillips curve, this is the region of either rate hikes or an inactive Fed”.
Not anymore, apparently. We’re in uncharted waters.
During remarks delivered at an event in Boston just a day before his infamous “long way from neutral” misstep in October, Powell weighed in on all of the above. “I do not see it as likely that the Phillips curve is dead”, he said. “Or that it will soon exact revenge”.