Economic Data Are Clear: Phillips Curve Points In the Wrong Direction

Federal Reserve Board watchers and economic commentators continue to emphasize reliance on the Phillips Curve, the theory that asserts that higher inflation leads to lower unemployment, and that reducing inflation raises the jobless rate.

Brookings Institution scholars, for example, laud the Phillips Curve’s “underlying logic” that “when there are lots of unfilled jobs and few unemployed workers, employers will have to offer higher wages, boosting inflation, and vice versa.” They cite it as “one key factor in the Federal Reserve’s decision-making on interest rates.”

The continued respect for the Phillips Curve is misplaced. It should have been confined to the policy dustbin long ago. Several Nobel Prize winning-economists, including Milton Friedman, Robert Hall, and Edmund Phelps, showed that the theory’s supposed trade-off between inflation and unemployment is at best short-term.

The last four decades of inflation and unemployment data are particularly damning for the Phillips Curve. The data show that the theory fails more often than not.

Since 1978, thirteen times an increase in annual inflation as measured by the Consumer Price Index has been followed in the next year by a decrease in the unemployment rate; and six times a decrease in annual inflation was followed in the next year by an increase in the unemployment rate. These nineteen data points support the Phillips Curve.

But twenty-one data points from the same period contradict the Phillips Curve. Seven times an increase in annual inflation was followed in the next year by an increase in the unemployment rate. Once, an increase in annual inflation was followed in the next year by no change in the unemployment rate. And thirteen times a decrease in annual inflation was followed in the next year by a decrease in the unemployment rate.

With more data contradicting it than supporting it, the Phillips Curve’s track record is worse than flipping a coin.

A picture of this data condemns the Phillips Curve more than a thousand words. As shown below, the theoretical Phillips Curve is downward sloping.

Image credit: Figure 2 in "The Phillips Curve" by OpenStaxCollege, CC BY 4.0

In contrast, the regression line for the scatter plot of the actual data shown below is upward sloping!

In other words, the data show that higher inflation does not lead to lower unemployment – and may instead lead to higher unemployment.

The connection between higher inflation and higher unemployment appears to be yet stronger when inflation exceeds three percent. This is shown by the more sharply upward regression line in the scatter plot below of the data points concerning years when inflation was over three percent.

The bottom line is that the economic data show that the Phillips Curve points in the wrong direction.