Market Perspectives: Five-Year Outlook

Back to basics: the Phillips curve

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The Phillips curve posits a relationship between unemployment and wage or price inflation. The theory is that when unemployment falls below a certain level, wage and price inflation begin to accelerate. That level is called the Non-Accelerating Inflation Rate of Unemployment or ‘NAIRU’. It cannot be observed directly and must be estimated. The problem is that it changes over time, influenced by demographics and market structure, among a host of other factors.

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With inflation continuing below central bank targets and minimal wage gains, is the Phillips curve still relevant? Is the consolidation of profits and the formation of oligopolies sustainable in the long run or will governments step in with policy changes?
 
Listen to the full episode here.

In the 1970s the NAIRU rose in the U.S.; the Federal Reserve misjudged the situation and allowed inflation to rise substantially. Restoring it to a reasonable level required time and much sacrifice in terms of lost growth and employment. Today the situation is reversed. Unemployment has fallen to exceptionally low levels, well below previous estimates of the NAIRU, while wage and price inflation have been subdued. Some have questioned whether the Phillips curve concept is still relevant.

After much analysis and discussion, we at BMO Global Asset Management have concluded that, while the relationship between unemployment and inflation is weaker than in the past and the NAIRU has fallen, the Phillips curve remains a useful tool for predicting inflation. In particular, there is a degree of non-linearity whereby marginal falls in unemployment from very low levels have a more powerful impact on inflation. Supporting evidence for these conclusions comes from work by Goldman Sachs’ economists, depicted in Charts A1 and B2. Chart A shows that the slope of the Phillips curve has decreased: the relationship still holds but is weaker. Chart B combines time series and cross sectional data on U.S. cities over the last 20 years and appears to suggest that the Phillips curve is steeper at low levels of unemployment, something that is expected and was evident in the original work.

Chart A: Impact of unemployment on inflation, OECD countries, 1970-2017

Chart B: Average core CPI inflation sorted by unemployment rate buckets, 1997-2017 quarterly for 13 biggest cities

1Note: Shaded area indicates +/- 2 standard error band. Source: Goldman Sachs Global Investment Research.
2Source: Goldman Sachs Global Investment Research.

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Named after the influential New Zealand economist, William Phillips, it describes a historical inverse relationship between rates of unemployment and corresponding rates of inflation that result within an economy.

 

Better conversations. Better outcomes. podcast

Looking ahead: 2018 Five-Year Outlook

Jon Adams, Senior Investment Strategist & Portfolio Manager at BMO Global Asset Management, joins our latest episode of the Better conversations. Better outcomes. podcast to discuss the importance of the forum, the three scenarios that could drive markets in the next five years and what each could mean for investors and portfolio positioning.
 
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More from the Five-Year Outlook

Five-Year Outlook
View the main highlights of this year’s Five-Year Outlook and download the full version and a condensed summary version of our investment outlook.
State of the world
The world economy has reached an unusual state of stability. Almost every country is seeing positive growth, but nowhere is growth booming out of control.
Steady as she goes (60% probability)
Our base case scenario, in which we see the global economy continuing to enjoy steady growth with modest inflation, despite the slight headwinds created by the gradual withdrawal of quantitative easing and higher interest rates.

 


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