A couple of weeks ago, I wrote a post
on the Fed’s success, or lack thereof, in meeting its dual targets of 5.5
percent unemployment and 2 percent inflation. The post featured the following
“bullseye” chart, which had first come to my attention when Chicago Fed
President Charles Evans used it in a recent speech.
James Hamilton has since used the same type of chart on Econbrowser.
It is a handy graphical device that looks likely to catch on.
The axes on the chart show the
unemployment rate and the inflation rate, as measured by the Fed’s preferred
index for Personal Consumption Expenditure (PCE). An alert reader of my post
commented that the axes are the same as those for a Phillips curve, yet the
recent trend, shown by the arrow, has a negative slope, exactly the opposite of
what the classic Phillips curve supposes. What is going on? Whatever happened
to the Phillips curve?
What the raw data do (or don’t) tell
The original paper by A. W. H.
Phillips, published in Economica in 1958 (downloadable here)
showed an impressively close inverse relationship between inflation and
unemployment for the British economy up to World War I, as shown in the next
chart. It also noted a similar, if slightly messier, relationship for the
However, if we make the same kind of
chart for the US economy over the past half-century, we see essentially no
correlation. The R2 is an insignificant .006 and the faint trace of
a trend, if we draw it in, runs in the wrong direction.
If that had been all there was to
see, popular writers, policymakers, and some academic economists would never
have seized on the Phillips curve as they did in the 1960s. They never would
have declared it a policy menu that allowed policymakers to choose a
combination of inflation and unemployment that suited their political tastes.
The curve never would have survived for fifty years as a staple of college
textbooks. To understand why the Phillips curve made such an impact, and to
judge whether there is anything left of it, we have to make a much closer
interpretation of the data. Here goes.
The Kennedy-Johnson years
The Phillips curve was at the height
of its popularity when John F. Kennedy became president in 1961. Kennedy had
been elected on a promise to “get the country moving again.” He and his successor,
Lyndon Johnson, set out to do so with the help of some of the best and
brightest economists of the day. We can catch the spirit of that self-confident
decade in this passage from the 1966 Economic Report of the President, written
by a Council of Economic Advisers consisting of Arthur Okun, Gardner Ackley,
and Otto Eckstein:
We strive to avoid recurrent
recessions, to keep unemployment far below rates of the past decade, to
maintain price stability at full employment . . . and indeed to make full prosperity
the normal state of the American economy. It is a tribute to our success . .
. that we now have not only the economic understanding but also the will
and determination to use economic policy as an effective tool for progress.
The result of their efforts at
economic stimulus was something that, at least at first, looked very much like
the classic Phillips curve, as we see in this next chart:
The only bothersome part of the
1960s expansion was the fact that the tradeoff between unemployment and inflation
appeared to getting less favorable over time. As that became increasingly
apparent, Milton Friedman and Edmund Phelps, among others, proposed an
explanation. The the positively sloped Phillips curve, they suggested, is only
a short-run relationship. The long-run Phillips curve is better represented as
a vertical line at the economy’s natural rate of unemployment. In the
Friedman-Phelps version, the short-run Phillips curve shifts up and down along
the long-run vertical curve as the expected rate of inflation changes.
The shifting Phillips curve and the
The next chart shows the dynamics of
inflation in a simple version of the shifting Phillips curve model. The
long-run Phillips curve is vertical at the assumed natural unemployment rate of
5 percent. The figure includes three short-run Phillips curves, each
intersecting the long-run curve at the corresponding expected rate of
In this simple version of the model,
we assume that each year’s expected rate of inflation is equal to the previous
year’s observed rate. The observed rates of inflation and unemployment for each
year are jointly determined by the position of the short-run Phillips curve and
the rate of growth of aggregate nominal demand. Finally, we assume that policymakers
alternately apply expansionary measures when they feel political pressure to
“do something” about unemployment and contractionary measures when they are
pressured to do something about inflation.
Putting all of these assumptions
together produces a dynamic in which the economy moves in a clockwise direction
around an irregular loop. Starting from equilibrium at point A, with moderate
inflation and unemployment at its natural rate, suppose that fiscal or monetary
stimulus increases the growth rate of aggregate nominal demand. With inflation
expectations still anchored at 2 percent, the economy moves up along SRP1 to
point B, where unemployment falls to 3 percent and observed inflation rises to
The 4 percent inflation observed at
point B raises the next year’s expected inflation to 4 percent, shifting the
short-run curve upward to SRP2. Assuming continued expansionary policy, the
economy next moves to point C.
At point C, inflation is a worrisome
6 percent. The government must do something, so it puts on the fiscal and
monetary brakes. However, the economy can’t simply slide back down along SRP2,
because the 6 percent inflation observed at point C has shifted the short-run
curve upward again to SRP3. Instead, contractionary policy pushes the economy
across to point D. We get the dread “stagflation” scenario where unemployment
rises even as the rate of inflation remains stubbornly high.
If the authorities have the
political fortitude to stick to a contractionary policy, they can eventually
purge the economy of inflation. In the next year, the economy would slide down
along SRP3 to point E. At that point, observed inflation is finally less than
expected, so the short-run Phillips curve begins to shift downward. In theory,
skillful policy could steer the economy back to a soft landing at point G,
right where it started.
Simple though it is, the
inflationary dynamics of this model correspond remarkably well to the behavior
of the US economy over the two decades following Kennedy’s inauguration. The
next chart plots the actual data. The main difference between the historical
pattern and the stylized version is that the loops of the historical stop-go
cycle seem to drift upward over time. A reasonable explanation would be that
policymakers react more rapidly and more strongly to political pressures to
reduce painfully high unemployment than to subsequent pressures to reduce
The Great Moderation
Just as it seemed that the stop-go
cycle with an inflationary bias might become a permanent feature of the US
economy, vindicating the shifting Phillips curve model, the picture changed.
The US economy entered a 20-year period now known as the Great Moderation. As
the next chart shows, during that period the unemployment and inflation rates
stayed remarkably close to the bullseye defined by the Fed’s current targets of
5.5 percent unemployment and 2 percent inflation.
During the Great Moderation, the
looping stop-go cycle so evident in the 1960s and 1970s becomes both diminished
and more irregular. It is hard to tell if the Phillips curve has disappeared
entirely in this period, but if it is still there, its effects seem to be
obscured by random shocks. The correlation of inflation and unemployment is
faintly positive and the R2 of just .025 is insignificant.
From the Great Moderation to the
The Great Moderation ended with the
Great Recession, which began in late 2007. The next chart compares the most
recent data to the behavior of the economy in the 1960s and 1970s. To sharpen
the focus, this chart differs in two ways from our earlier ones. First, it
shows quarterly rather than annual data. Second, it shows data only for the
trough-to-peak phases of the business cycle (recovery and expansion), leaving
out quarters in which GDP decreases. Because the main purpose of the chart is
to compare the recent expansion with those of the 1960s and 1970s, when the
shifting Phillips curve model was clearly operating, it omits the four cyclical
recoveries between 1980 and 2006.
The three earlier cycles are similar
in certain ways that we can explain easily in terms of the shifting Phillips
First, the earlier recoveries all
begin with a phase during which the rate of inflation begins to fall while the
unemployment rate is still rising. In the shifting Phillips curve model, that
pattern can occur when tight fiscal and monetary policy restrain the growth of
aggregate nominal demand while falling inflation expectations are shifting the
short-run Phillips curve progressively downward. According to the model, the
rate of unemployment should still be above the natural rate during this phase
of the recovery, as it appears to be. The CBO estimates that the natural rate
rose from about 5.5 percent in 1960 to about 6.5 percent by 1980, which would
explain the rightward drift in the first three recovery tracks shown in the
Second, in each of the three early
cases, inflation and unemployment both begin to rise no later than seven
quarters into the recovery. The subsequent segments are the ones that look
superficially like classic negatively-sloped Phillips curves, but are better
explained as the result of expansionary policy acting on a short-run Phillips
curve that is shifting upward under the influence of rising inflation
expectations. The shifting-curve model suggests that unemployment should fall
below its natural rate as inflation accelerates, which seems generally
consistent with the data.
Good data on inflation expectations
for the 1960s and 1970s would bolster the shifting curve model as an
explanation of the patterns followed by the three early recoveries shown in the
chart. Unfortunately, data on expectations for those years is skimpy. In an
attempt to fill the gap, a recent study
by Jan Groen and Menno Middeldorp of the New York Fed attempts to construct a
proxy series for inflation expectations that reaches back to the 1970s. Their
reconstruction is consistent with the notion that inflation expectations fell
in the early part of the recovery of 1975 to 1980, but it does not go back far
enough to cover the two earlier recoveries.
Let’s turn now to the recovery from
the Great Recession, which began in mid-2009. Its pattern is very different. As
in the early cycles, the unemployment rate lags behind GDP and continues to
rise in the first few quarters of the recovery. However, in this case, the rate
of inflation rises, rather than falling, in the early part of the recovery. It
does not reach its mid-recovery peak of 2.9 percent until the third quarter of
During the whole period from Q3 2009
to Q3 2011, unemployment is far above its natural rate. It is impossible to
produce the combination of rising inflation together with unemployment that is
both rising and above the natural rate with a simple shifting Phillips curve.
In that model, unemployment can be above the natural rate only if the observed
rate of inflation is less than the expected rate, and that, in turn, would
cause a steady downward shift of the short-run Phillips curve from quarter to
quarter. Under those circumstances, either the unemployment rate or the
inflation rate would have to fall from quarter to quarter.
After Q3 2011, the current recovery
takes a different direction. From then until the most recent observations, the
trend has been falling unemployment combined with falling inflation. It is
technically possible to produce that result in the shifting Phillips curve
model if we combine an unemployment rate initially above the natural level,
falling inflation expectations, and demand management policy that is gradually
becoming more expansionary. A few short segments seem to fit that pattern
during the earlier cycles, most notably the period from the fourth quarter of
1975 through the fourth quarter of 1976.
The problem is that there is no
evidence of falling inflation expectations in the most recent period. If anything,
as the next chart shows, inflation expectations have been gently rising from
mid-2011 to the present. Without falling inflation expectations, the shifting
Phillips curve model is incapable of producing a sustained period during which
both the inflation rate and the unemployment rate decrease.
The bottom line
This post began with the question,
What ever happened to the Phillips curve? We now have our answer.
The classic stationary Phillips
curve—the version that people once optimistically viewed as a stable policy
menu—died long ago. Already by the end of the 1960s, the Friedman-Phelps
shifting Phillips curve model had taken its place. In our simplified version,
that model has these four components:
- A vertical long-run Phillips curve
- A negatively sloped short-run Phillips curve that
intersects the long-run curve at the expected rate of inflation
- An expected rate of inflation primarily determined by
observed inflation in the recent past
- Aggregate nominal demand as the determinant of the
economy’s position along the short-run Phillips curve that applies at any
When we combine these assumptions
with fiscal and monetary policies that react to alternating political pressures
to do something about unemployment and then do something about inflation, the
shifting Phillips curve model produces a stop-go cycles very much like observed
from the early 1960s through the mid-1980s.
After that, even the shifting
version of the Phillips curve runs into trouble. Its usefulness begins to fade
already during the Great Moderation, and it becomes altogether incapable of
producing the pattern of inflation and unemployment we see during the first
five years of the recovery from the Great Recession. The reason appears to be a
breakdown of two of its key principles, first, that unemployment higher than
the natural rate can occur only when inflation is slower than expected, and
second, that inflation persistently slower than expected must cause a downward
revision of expectations.
Instead, what we see during the past
five years is persistently high unemployment combined with low and stable
inflation expectations and a falling observed rate of inflation. If the
Phillips curve is not dead, we must at least declare it in a persistent
vegetative state from which it will not awaken without some radical change in