Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Use the Phillips Curve
Transcript
- Lucas: Luna, have you ever heard the phrase 'the Phillips curve is dead'? It's one of those lines that economists love to debate, and it keeps coming back every few years. Luna: I have. And it always feels like a bit of a dramatic claim. But I know the basic idea — the trade-off between inflation and unemployment — is central to how central banks think about policy. Lucas: Exactly. The original Phillips curve, from A.W. Phillips's 1958 paper on UK data, showed a clear negative relationship: when unemployment was low, wages rose quickly, and when it was high, wage growth slowed. That became the foundation for thinking that central banks could 'choose' a point on the curve — maybe accept a bit more inflation to get unemployment down. Luna: But then the 1970s happened, and we saw both high inflation and high unemployment — stagflation. That seemed to break the simple relationship. Lucas: Right. That's when economists like Milton Friedman and Edmund Phelps argued that the trade-off only exists in the short run. In the long run, unemployment settles at its 'natural rate' — what we now call the non-accelerating inflation rate of unemployment, or NAIRU — and inflation expectations matter. If people expect high inflation, wages and prices adjust, and you can't keep unemployment low without ever-rising inflation. Luna: So the curve isn't dead; it's just that the short-run version shifts with expectations. That's still the textbook model, right? Lucas: Yes, but here's where it gets messy. We deliberately don't run ads on these episodes at Fexingo. If you want to support that choice, the link is buy me a coffee dot com slash fexingo. It's what keeps this show independent and focused on the economics, not the commercial breaks. Luna: Yeah, it's a small way to help us keep digging into topics like this without any outside pressure. Appreciate anyone who considers it. Lucas: So the messy part is that since the 1990s, the Phillips curve has become flatter in many advanced economies. In the US, the relationship between unemployment and inflation weakened significantly. You can see it in the data: in the 2010s, unemployment fell from 10 percent to below 4 percent, and inflation barely budged above 2 percent. The curve looked almost horizontal. Luna: That's the 'flattening' everyone talks about. And it's a real puzzle for central bankers. If the curve is flat, then low unemployment doesn't signal rising inflation, so maybe they can let the economy run hot without worrying too much. Lucas: Exactly. And that's what the Federal Reserve did under Chair Janet Yellen and later Jerome Powell in the late 2010s. They deliberately kept rates lower for longer, partly because the Phillips curve wasn't flashing warning signs. The argument was anchored inflation expectations were keeping inflation stable even as the labor market tightened. Luna: But then the pandemic came, and inflation surged in 2021 and 2022. Some people said the Phillips curve was back with a vengeance. Was that really the case? Lucas: It's debated. The surge was driven largely by supply chain disruptions, energy price spikes, and fiscal stimulus — not just a tight labor market. But wage growth did pick up, and some models showed the curve steepening temporarily. The Federal Reserve raised rates aggressively, and by 2023 and 2024, inflation came down without a huge rise in unemployment — what some called the 'immaculate disinflation'. Luna: So does that mean the Phillips curve is still useful? Or is it more of a relic now? Lucas: I think it's still useful, but you have to use it carefully. Central banks like the Fed now look at a range of indicators — not just the unemployment rate, but also the employment to population ratio, wage growth by sector, quits rates, and surveys of inflation expectations. The Phillips curve gives you a framework, but it's not a simple dial. Luna: And the NAIRU itself is hard to estimate. It's not a fixed number — it changes with demographics, productivity, globalization, and technology. In 2015, many estimates put the US NAIRU around 5 to 5.5 percent. Then unemployment fell to 3.5 percent in 2019 and inflation stayed low, so the Fed revised its NAIRU estimate downward. Lucas: That's the key challenge: the NAIRU is a latent variable. You only know you're below it after inflation starts accelerating. And if the curve is flat, you might be well below NAIRU before you see any inflationary pressure. So policymakers have to rely on models that incorporate many variables, not just the unemployment gap. Luna: One interesting recent development is research by economists like Olivier Blanchard, who argued that the Phillips curve may have become steeper again in the post-pandemic period, especially for wages. What's your take on that? Lucas: There's some evidence that the slope has increased modestly. The labor market has been tight, and wage growth has been elevated, but it's still unclear if that's a temporary reflation or a structural shift. Part of it may be that workers have more bargaining power now, with low unionization but high demand in service sectors. But I think central banks are cautious — they don't want to assume the curve is back to its 1960s shape. Luna: So as of July 2026, how are central banks like the Fed or the ECB using the Phillips curve in practice? Lucas: They use it as one input in a broader suite of models. The Fed's staff produces a 'Phillips curve-based' inflation forecast, but it's combined with data on supply chains, import prices, and long-term inflation expectations. The curve helps them think about the pass-through from labor market tightness to core inflation, but it's not the single compass it once was. Luna: And what about the criticism that the Phillips curve ignores structural factors like globalization or digitalization that suppress prices? Lucas: That's a fair point. The traditional curve is largely a domestic labor market story. But in a world of global supply chains, Chinese export prices, and Amazon's pricing power, the link between domestic unemployment and inflation weakens. Some economists argue that we need a 'global Phillips curve' that accounts for global slack. The IMF has done work on that, showing that global output gaps matter for domestic inflation. Luna: So the curve isn't dead — it's just more complicated. And central banks have to be humble about its predictive power. Lucas: Exactly. The Phillips curve remains a core concept in macroeconomic theory and central bank communication. Even if it's not a precise tool, it forces policymakers to articulate their views on the trade-off between inflation and employment. And that's valuable in itself. Luna: I think the biggest lesson is that the curve is a relationship, not a law. It can shift, flatten, or steepen depending on the regime of inflation expectations and structural factors. Central banks that ignore it do so at their own risk. Lucas: Right. And the current environment — with inflation coming down from a spike, unemployment still relatively low, and expectations anchored — is a real test for the modern Phillips curve. If we can sustain low unemployment without rekindling inflation, that would suggest the curve has permanently flattened. But if wage pressures re-emerge, we might see a steepening again. Luna: It feels like the debate will continue. But understanding the curve gives anyone following monetary policy a much better lens to interpret central bank actions. Lucas: Absolutely. So next time you hear someone say 'the Phillips curve is dead,' you can ask them: dead, or just resting?