You Can Buy Lower Unemployment With Inflation Only Once
The Phillips curve says low unemployment produces rising inflation. It held, then failed badly, then was rebuilt around expectations, and it still underpins how central banks think.
The Original Observation
The initial finding was empirical: periods of low unemployment coincided with higher wage growth, and periods of high unemployment with lower wage growth. Plotted, it produced a downward sloping curve.
The intuition is straightforward. When few workers are available, employers compete for them by raising wages, and those costs feed into prices.
The Policy Temptation and the Failure
If the relationship is stable, it presents a menu. A government could accept somewhat higher inflation in exchange for permanently lower unemployment.
Attempts to exploit that tradeoff failed. Economies experienced high unemployment and high inflation simultaneously, which the simple relationship said should be impossible.
The relationship was not a law being violated. It was a pattern that held only while people were not expecting the policy that exploited it.
The Rebuild Around Expectations
The resolution was that the relationship depends on inflation expectations. Workers care about real wages, meaning purchasing power, not the number on the payslip.
If everyone expects prices to rise five percent, wage demands start at five percent before any labour market tightness is considered. The tradeoff then exists only between unemployment and inflation relative to what was expected, not against inflation in absolute terms.
The implication is severe: there is no permanent tradeoff. A government can push unemployment below its sustainable rate temporarily by generating inflation people did not anticipate. Once they anticipate it, expectations adjust, and the economy returns to the same unemployment rate with higher inflation embedded.
| Regime | What the relationship looks like |
|---|---|
| Expectations well anchored | Flat, inflation stable despite tightness |
| Expectations drifting | Steep, wage price spiral possible |
| Unanticipated policy | Temporary tradeoff appears |
Why Anchoring Became the Whole Job
This is the intellectual foundation of modern central banking. If expectations determine whether the tradeoff exists, then keeping expectations anchored is the central task.
It explains independence, since a central bank insulated from short term political pressure is more credible when it says it will not tolerate inflation. It explains explicit targets, which give expectations something concrete to anchor to. And it explains why central banks talk so much, because managing expectations is a substantial part of managing inflation.
The Flattening Puzzle
For an extended period the observed relationship became very flat. Unemployment fell to low levels without producing the inflation the historical relationship implied.
The explanations offered include successfully anchored expectations, which is the reassuring reading, global competition limiting the ability of firms to raise prices, weakened worker bargaining power, and mismeasurement of how much slack actually remained.
A flat curve is comfortable while it lasts and it carries a warning. If the flatness comes from anchored expectations rather than from a broken relationship, then it depends on those expectations holding, and it would steepen quickly if they came unanchored.
What Recent Experience Suggested
Episodes where inflation rose sharply and then fell without a large rise in unemployment do not fit the simple relationship well. They suggest that supply disruptions and shifts in demand composition can drive inflation through channels having little to do with labour market tightness.
The honest summary is that the labour market is one input into inflation among several, and treating it as the primary one has led policy astray in both directions.
The Bottom Line
The Phillips curve describes a relationship that exists conditionally rather than mechanically. There is no lasting tradeoff between unemployment and inflation, only a temporary one when inflation surprises people. That makes anchoring expectations the core of central banking, and it means a flat curve is evidence of credibility rather than evidence the relationship has gone away.