The Phillips Curve and the Fed

The shape of the US Phillips curve should be the most important economic debate for policymakers currently. The Phillips curve is an economic model describing the inverse relationship between wage growth and unemployment i.e. at low levels of unemployment, wage growth should be higher. While this relationship has held true over time; during the last few decades the Phillips curve has been low and very flat meaning that despite unemployment rates at times being at low levels, wage growth has not been very responsive. One interpretation of a flat Phillips curve is that monetary policy is ineffective in stimulating inflation. Many monetary policymakers bemoaned this fact last cycle as the flatness of the curve made it difficult to increase inflation despite policy rates set at the zero-bound. However, the interpretation that I prefer for a flat Phillips curve is that it means that inflation is relatively uncorrelated with the tightness in the labor market.

In a world where inflation is uncorrelated with the tightness in the labor market you do not need to use the Taylor Rule to set monetary policy. The Taylor Rule is an econometric model devised by John Taylor that argues that the Federal Funds rate target should be set based on an estimate for an economy’s neutral rate and deviations between inflation and unemployment relative to the Fed’s targets. In the last cycle, most Central Banks abandoned it, and the reason they were so quick to dismiss it was because inflation expectations were very well anchored and more importantly inflation had been a very poor indicator of the cycle since the mid-1990s. Instead, it was the financial markets that were better leading indicators for when a recession was imminent. There was also a lot of humility from the economic community after the Global Financial Crisis with many economists pushing for a complete abandonment of the universal economic models that used inflation as the key input into their understanding of the business cycle. From a practical standpoint, the Central Bankers lost confidence in their ability to predict the natural rate of unemployment (NAIRU) and inflation, so they needed to produce a new framework to guide monetary policy.

That new policy was a neutral rate framework. The idea behind it is that if inflation expectations are anchored (if not below long-term targets), the Fed should set interest rates based on a long-term view of the neutral rate. The short-term neutral rate, a rate that is unknowable, is the level at which monetary policy is neither restrictive nor expansionary to economic growth with inflation at target. This policy guided the Fed’s decisions from December 2015 to COVID. The Fed’s goal was to march policy rates higher towards their conception of the neutral rate. However, this was not on autopilot and the Fed looked to the financial markets to tell them when they reached or even exceeded neutral. For example, the early 2016 oil crisis caused Chair Yellen to alter the Fed’s forward guidance. Similarly, in December 2018 the Fed thought the neutral rate was closer to 2.5%, but the market sell-off told Chair Powell that the policy rate was too high (I have long argued the neutral rate could have been higher and it was Quantitative Tightening that was the problem, but that is not how central bankers understand it). The Powell Fed cut rates to 1.75% in 2019, largely because in their view they had overestimated where the neutral rate was.

It is important to think of why a Phillips curve is flat. Economists would ascribe a number of reasons, but the two most important to me are the relative availability of labor and central bank credibility. The first reason explains why we have had a flat Phillips curve since the mid-1990s. The emergence of China and offshoring meant that when wage pressures started to rise domestically, companies could easily relocate their factories abroad to maintain their profit margins. Immigration into the US also allowed a low unemployment rate to not necessarily mean higher wage inflation.

The second reason for a flat Phillips curve is the success that Central Banks have had in anchoring inflation expectations over the past 40 years. The Phillips Curve was flat, because the Fed has gained credibility that if inflation got too high, they would combat it. However, this hard-won credibility should not be taken for granted. Chair Powell said it best in a speech in 2018 on the Phillips curve:

“We should also remember that where inflation expectations are well anchored, it is likely because central banks have kept inflation under control. If central banks were instead to try to exploit the non-responsiveness of inflation to low unemployment and push resource utilization significantly and persistently past sustainable levels, the public might begin to question our commitment to low inflation, and expectations could come under upward pressure.” – Powell, June 2018

Many have been surprised by the abrupt change in the Fed’s rhetoric over the past 9 months, but the need to maintain inflation credibility and keep the Phillips Curve flat is the main reason for this meaningful pivot.

So what does the Phillips curve look like in the post-COVID world? The question becomes whether it has steepened, perhaps temporarily, or whether it is flat and high. If the Phillips curve is steep than a neutral policy framework does not apply, and you need to use something like the Taylor Rule to set monetary policy again. This is bad news, because the Taylor Rule would say that interest rates need to be much higher than they are currently given the deviation from potential growth and NAIRU. However, assuming that eventually inflation will steady to something closer to a 3% PCE (a big assumption), the neutral rate is -0.5% and NAIRU is 4% suggests a policy rate that is higher than last cycle, but not back to pre-GFC levels.

There are certainly some reasons to believe that the Phillips Curve is steeper. There is still ~$2 trillion in excess savings but based on some estimates only $600bn is in the hands of the bottom 4 quintiles of the income distribution. Inflation will wipe through those excess savings by the end of the year. Perhaps, then we will start to see the prime age labor force participation rate start to rise dampening some wage pressure. Similarly, when excess savings makes their way out of the system than companies will not have the ability to pass on price increases without hurting demand. The hope is that companies will invest in capital expenditures (capex) to raise structural growth rate, but it is more likely that companies will try to protect their margins by reducing their workforce. In a steep Phillips curve environment, the Fed’s rate hikes will be effective in slowing growth and inflation and we should see this quickly as the Fed normalizes policy. It may take a recession, but when that occurs inflation should come down towards to the 2% target. This is not a terribly scary world, because long-term interest rates can stay anchored even if short-term interest rates will need to approach something closer to a longer-run Taylor Rule. A recession would obviously not be great for risk assets, but it would be short-lived, and the Fed could even ease when inflation pressures started to subside and the unemployment rate began to rise. It is in this environment where buying the dip in equities/credit should work well.

There is a substantial risk though that the Phillips curve is higher and flat. The reasons for this change would primarily be de-globalization in that companies will have learned that having your supply chains in countries’ with too stringent COVID policies makes it difficult for you to effectively run your business and geopolitics changes where you will be allowed to have your supply chain. There is not enough capital investment in the US to immediately handle this shift so switching from labor to capital is not possible even with these constraints. The other reason for the high, but flat Phillips curve is persistently high commodity prices, which could continue in the wake of the Russian invasion of Ukraine.

A flat but high Phillips Curve is a terrible environment for asset prices, because the Fed will find that despite raising interest rates, inflation is uncorrelated and high. Powell would be forced to make the choice that Paul Volcker made, which is that he would need to engineer an extremely large recession to anchor inflation expectations at the 2% level. There is nothing magical about the 2% target the Fed has set, and the Fed could easily revise their target higher to 3%. However, I think it will take a long time for that change to occur and policy rates would need to go much higher before they threw in the towel on their inflation target.

However, there is a substantial constraint on the Fed that did not exist during Paul Volcker’s time as Federal Reserve, the Chairman who broke the back of sticky inflation in the late 1970s/early 1980s. The country has substantially more debt than we did in the 1980s (see chart below). Volcker was dealing with a high and flat Phillips curve that was a result of the stop-go inflationary policies of the 1970s. Volcker just needed to credibly show the market that despite the economic slowdown, he would not ease the policy rate till inflation came down. The stock market ultimately responded well during and after the economic weakness, because anchored inflation expectations are good for asset prices. But Volcker could raise policy rates so aggressively because the country overall had very low levels of debt. The financial markets could withstand 16% policy rates without breaking and the government could still finance itself at those levels.

Source: Federal Reserve, Bureau of Economic Analysis

We are in a very different regime where debt levels, particularly at the Federal level are extremely high relative to history. Let us imagine an extremely flat yield curve of 4%. If this persisted, over time about 30% of Federal Revenue would need to go towards debt service, and this does not include the entitlements that are ballooning as the baby boomers continue to retire. The only way to pay for this is a large fiscal contraction. I would not underestimate this possibility, but if it occurred it would be very problematic for equity markets. While we tend to think of profits as microeconomic in nature, they can also be defined by a macroeconomic equation called the Kalecky-Levy profit equation. Fiscal expansion is one of the main components in this equation, which is why corporate profits were so robust throughout the pandemic and continue to be so today.

Besides the governmental sector, the non-financial corporate sector also has elevated levels of debt historically. While free cash flow (FCF) to debt is at record levels, there are reasons to believe that this has peaked as well. As mentioned, fiscal expansion is necessary for profits, but also the increased capital expenditures necessary to change supply chains will likely mean lower FCF margins going forward. It is also worth thinking about how many business models are effectively levered too low rates. Share buybacks has been one of the main reasons for the resiliency of equity markets since the GFC and the boost in return on equity and earnings per share; the relative cost of maintaining this when companies need to expand capex introduce new sets of winners and many more losers.

This is another way of saying that the long-term neutral rate for the economy is still very low. The long-term neutral rate is not determined by short-term inflation and growth, but rather by things like demographics, the savings/investment balance, productivity and debt levels. In my mind, the long-term neutral rate is still very negative in the US, and if anything the pandemic made it worse with more elevated debt levels, lower trend labor force participation growth and lower productivity. If the Fed chooses to normalize its policy rate above neutral than financial conditions will tighten dramatically driven by a fall in equity prices and credit. Yet, the recession this would induce is unlikely to cause a drop in inflation if the Phillips curve is flat. This is an environment where you do not buy the dip, where real rates and credit spreads stay elevated, and it takes a long-time for the Fed to realize that inflation is now high at a persistent level. It is this scenario that the market has been grappling with since the end of the last quarter. Real rates recently broke out of their range at the same time inflation breakevens have also started to rise; this is what you would see in a high and flat Phillips Curve environment.

The question for the Fed is what they would do with a recession, higher unemployment rates but sticky and high inflation rates. My guess is that eventually they would be forced to raise their inflation target higher. It is also likely that they will need to restart their QE program to cap long-term rates at a certain level, which would mean a much weaker US dollar eventually. The reality is that we have so much debt in the US that you need nominal growth to stay higher than the overall cost of debt in the economy to allow the overall system to delever. Only then can policy rates be normalized to levels we saw before the GFC without substantially destroying asset values. Thus, the shape of the Phillips Curve as well as the Fed’s reaction to it is the key determinant of asset prices over the next few years.

Important Disclosures

For professional, institutional and accredited investors only. The views expressed are those of the author and are subject to change. Other teams may hold different views and make different investment decisions. While any third-party data used is considered reliable, its accuracy is not guaranteed. Forward-looking statements should not be considered as guarantees or predictions of future events. The value of your investment may become worth more or less than at the time of original investment. Past results are not a reliable indicator of future results. Commentary provided should not be viewed as a current or past recommendation and is not intended to constitute investment advice or an offer to buy or sell securities. Wellington assumes no duty to update any information in this material in the event that such information changes.