Monetary Policy and the Phillips Curve

Louis-Philippe Rochon
Full Professor of Economics, Laurentian University
Editor-in-Chief, Review of Political Economy
Founder and Editor Emeritus, Review of Keynesian Economics

From the perspective of mainstream theory, the effectiveness of monetary policy in bringing down inflation depends on two very important equations: the aggregate demand equation and the infamous Phillips Curve. Without these, it becomes more difficult — or rather impossible — for central banks to carry out monetary policy and obtain the results they expect.

Let me break it down.

The first relationship, the aggregate demand curve, suggests that when central banks increase interest rates, both consumption and investment will come down (given their alleged interest sensitivity), thereby bringing down GDP along with them. Students of economics also know this as the IS curve. Once output is down, the second relationship, or the Phillips Curve, kicks in: it implies that as output falls, unemployment increases, which in turn should bring inflation down.

Yet there is plenty of empirical evidence to suggest that both consumption and investment do not respond significantly enough to these incremental changes in interest rates. Among the many studies, my favourite is this one, from two economists working for the Federal Reserve: “A large body of empirical research offers mixed evidence, at best, for substantial interest-rate effects on investment. [our research] find that most firms claim their investment plans to be quite insensitive to decreases in interest rates, and only somewhat more responsive to interest rate increases” (https://www.federalreserve.gov/pubs/feds/2014/201402/201402pap.pdf).

Strike one.

How about the Phillips curve? Well, the long, long list of those now arguing that the curve has flattened is getting even longer. Traditionally, the Phillips curve was a smooth negative relationship between inflation and unemployment. When one goes up, the other goes down, as in Figure 1.

This suggests that if central banks want lower inflation, they would need to raise unemployment.

But there is now plenty of empirical evidence that this stable relationship no longer holds. Instead, it now seems that a given rate of inflation is associated with multiple unemployment rates: the relationship is no longer unique. The Philipps Curve has flattened.

You want proof? How about the following from a former governor of the Federal Reserve?: “The substantive point is that we do not, at present, have a theory of inflation dynamics that works sufficiently well to be of use for the business of real-time monetary policy-making”

Claudio Borio, chief economist at the Bank for International Settlements, had this to say: “the response of inflation to a measure of labour market slack has tended to decline and become statistically indistinguishable from zero. In other words, inflation no longer appears to be sufficiently responsive to tightness in labour markets,” and again more recently: “inflation has proved unexpectedly unresponsive to economic slack — the Phillips curve is very flat.”

Strike two.

So what does this all mean?

It means that if these two relationships are proven statistically insignificant, central banks can no longer rely on well-behaved relationships to deliver inflation on target. The entire apparatus on which monetary policy rests upon collapses, and with it, all current efforts to curb inflation around the world. In Figure 2, we can see that if central banks insist on lowering inflation, it will have to push unemployment to great heights.

It is in this sense that in a forthcoming book co-edited with Sylvio Kappes and Guillaume Vallet on The Future of Central Banking, I refer to the ‘ineffectiveness of monetary policy.’

But central bankers are refusing to give up on this model as it is the only one they know, and in order to save face and restore their credibility, they will push forward with repeated increases in interest rates. They will be sliding along that flat portion of the Phillips curve until the economy comes crashing down. As a result, they will need to push unemployment so high and engineer a recession if they want inflation to come down. This is the so-called Volcker shock

And it seems this is what they are prepared to do. Let’s be clear on what this means: central banks are prepared to sacrifice the income of workers in order to protect the wealth of others. It is precisely in this sense that David Fields recently stated in his blog for the Monetary Policy Institute that monetary austerity is social conflict. Let’s just see how ‘strongly committed’ they are to this.

But the story does not end there. Given the above discussion, there is more. Indeed, as if the arguments above were not bad enough, they would only apply if inflation were of a demand-pull nature. The whole mainstream policy edifice is based on impacting demand, and therefore prices. But what if inflation is not demand-determined? There is considerable consensus that current inflation is not demand-pull, that it resulted from factors such as oil and natural gas, rents, and supply chain issues. There are problems that depend more on international conditions, over which national central banks have no control. So all these increases in interest rates won’t solve anytime soon the problem of inflation in 2022.

Strike 3.