NCPA - National Center for Policy Analysis

Is The Phillips Curve Dead?

April 14, 1999

Central bankers have considered low inflation and low unemployment to be incompatible. So to keep inflation in check they keep interest rates higher than necessary, which slows growth, holds down incomes and creates worries for the stock and bond markets.

Interestingly, there is no logical connection between inflation and unemployment. The concern is based entirely on a perceived historical relationship called the Phillips Curve, which shows that high inflation is associated with low unemployment and low inflation is associated with high unemployment. Thus there is always an implied trade-off.

Over the last six years, however, the inflation-unemployment trade-off seems to have broken down.

  • Since 1993, the national unemployment rate has fallen from 6.9 percent to 4.2 percent currently.
  • Meanwhile, the inflation rate has also fallen from 2.7 percent in 1993 to just 1.6 percent last year.

Some members of the Federal Reserve Board have begun to rethink their traditional Phillips Curve model. The latest is vice-chair Alice Rivlin, who told the Financial Times last week that perhaps a new era has emerged in which low unemployment does not cause higher inflation.

At the Fed's last board meeting in February, the members noted that current favorable economic conditions "could not be explained in terms of normal historical relationships," according to the minutes. The continuation of low inflation, however, may be due to "lasting changes in economic relationships," rather than temporary factors. These include stronger competitive pressures on businesses, leading to higher investment and higher productivity.

Also, in the February issue of the Monthly Labor Review, the Labor Department concedes that its measures of productivity may be off. True productivity growth may be greater than that recorded in the government's official statistics. If true, this could well explain why businesses have been able to raise profits without raising prices.

Source: Bruce Bartlett, senior fellow, National Center for Policy Analysis, April 14, 1999.


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