Central banks across the developed world are coming to grips with some difficult questions this year, such as why the Phillips curve is broken.
Developed by AW Phillips in the late 1950s after studying a century’s worth of economic data dating back to 1850, Phillips discovered that employment and inflation data had an inverse relationship.
That is, as the unemployment rate fell, inflation would rise. The theory suggests that the two would drive economic growth, increasing consumption and investment along the way, leading to more jobs and economic growth.
The problem with the Phillips curve is that it was largely disproved during the period of stagflation in the US in the 1970s.
Yet major central banks, including the Federal Reserve, the Bank of Canada and even the Reserve Bank of Australia (RBA) use it as a key forecasting tool.
Nevermind that it was proven to be inaccurate 50 years ago…
Yet today, this oversimplified economic tool isn’t telling central banks what they want to see. And, gallingly, they are surprised about it.
Take this from RBA governor Philip Lowe, who touched on the subject earlier this year:
‘This scenario is one in which the Phillips Curve is flatter than it once was. It is one in which inflation is harder to generate. We can’t yet tell though whether the Phillips Curve in Australia has become flatter, given that we have experienced relatively little variation in the unemployment rate over recent times.’
While it’s true that official unemployment data from the Australian Bureau of Statistics (ABS) has changed very little over time, alternative unemployment statistics from Roy Morgan suggest that the rate has varied from 5.3–11.7% since October 2005. The ABS on the other hand has the unemployment rate ranging from 5–6.1%.
So it’s no surprise to learn that the Phillips curve is broken when the statistics used to measure it are faulty.
For central banks, there’s a simple reason why they support following the Phillips curve: If inflation increases, so too will consumption.
Driving that theory has been a decade of loose monetary policy. The problem is that it hasn’t worked. Economies haven’t returned to ‘normal’. Instead, easy money has filtered through the financial system into places of least resistance.
It’s even led to the Bank of International Settlements (BIS) — the central bank to the central banks — to stick its neck out in April this year.
In a paper called ‘Is monetary policy less effective when interest rates are persistently low?’, the BIS explained that low interest rates are in fact bad for the economy, writing:
‘From a historical perspective, this persistently low level of short- and long-term nominal rates is unprecedented. Since 1870, nominal interest rates in the core advanced economies have never been so low for so long, not even in the wake of the Great Depression of the 1930s
‘The persistently low rates of the recent past have reflected central banks’ unprecedented monetary easing to cushion the fallout of the Great Financial Crisis (GFC), spur economic recovery and push inflation back up towards objectives.
‘However, despite such efforts, the recovery has been lacklustre. In the core economies, for instance, output has not returned to its pre-recession path, evolving along a lower, if anything flatter, trajectory, as growth has disappointed. At the same time, in many countries inflation has remained persistently below target over the past three years or so.’
The BIS also published this chart:
Source: Bank of International Settlements
[Click to enlarge]
That is over a century of data showing real and nominal interest rates. In the past 10 years, central banks have dropped rates to levels they’ve never been before.
What persistently low rates have done, however, is prop up other sectors of the Australian economy.
Rather than show up in inflation, global record low interest rates have not only prolonged the monetary stimulus cycle, but it’s forced investors to place their cash anywhere that seems likely to return a profit.
The problem is that all this profit-chasing is forcing key areas of the market to look overheated. So much so that Bloomberg created the ‘Bubble Galaxy’ chart to illustrate assets that appear overbloated:
[Click to enlarge]
As major central banks around the world continue to focus on consumption inflation — and not asset price inflation — over-inflated prices are popping up everywhere.
Continuous stimulus — either in the form of low interest rates or central banks buying bonds — hasn’t encouraged people to spend money in the Australian economy. No, instead of boosting consumption, the outcome of central bank fiddling has seen enormous potential asset bubbles form in only a few sectors of the market.
An additional accidental consequence of the ongoing central bank intervention has been the effect of how wealth is distributed throughout the economy. Real wealth has been obscured by rising asset prices, but income inequality has risen as real wages have remained flat.
Central bankers may be confused as to why the Phillips curve is broken. But the outcome of a decade of unrelenting central bank intervention has set the global economy up for disaster. Or, as The Gowdie Letter editor Vern Gowdie points out, the debt cycle could unravel much sooner than we realise.
Editor, Markets & Money