Question

Lael Brainard, a member of the Federal Reserve's Board of Governors, delivered a speech in 2017 that included this observation: "At a time when the unemployment rate has fallen from 8.2 percent to 4.4 percent, core inflation has undershot our 2 percent target for 58 straight months. In other words, the Phillips curve appears to be flatter today than it was previously." Briefly explain why the data Brainard cites indicate that the Phillips curve in 2017 was relatively flat.

Short answer

The Phillips curve was relatively flat in 2017 because, despite a significant decrease in the unemployment rate from 8.2% down to 4.4%, the inflation rate remained below the 2% target for a protracted period of 58 months. This indicates a weak or negligible correlation between inflation and unemployment, contrary to the classic negative correlation posited by the Phillips curve.

Step-by-step solution

Understanding the Phillips Curve

The Phillips curve is an economic concept that states that inflation and unemployment tend to have an inverse relationship. As unemployment decreases, inflation should increase, and vice versa. A 'flatter' Phillips curve suggests that the relationship between inflation and unemployment isn’t as strong, because variations in unemployment do not result in significant changes in inflation.

Analyzing the Historical Data

According to the data provided, the unemployment rate fell sharply from 8.2 percent to 4.4 percent, which is almost half of the initial rate. If the Phillips curve were steep (strong negative correlation), this sharp decrease in unemployment would likely correspond with a significant increase in inflation. However, this was not the case as core inflation remained below the target of 2 percent for 58 continuous months.

Drawing Conclusions from the Data

Since the inflation undershot its target while the unemployment rate fell, this indicates a 'flatter' Phillips curve. This implies a weak or possibly no correlation between the unemployment and inflation rate during the period Brainard is referring to (2017). Thus, the data Brainard discloses indicates that the Phillips curve was relatively flat – meaning the inverse relationship expected between inflation and unemployment did not distinctly occur in the U.S. economy at that time.

Key concepts

Inflation Rate

Understanding the inflation rate is essential when examining the health of an economy. It represents the rate at which the general level of prices for goods and services is rising, and subsequently, how purchasing power is falling. Central banks, such as the Federal Reserve, strive to maintain a stable inflation rate. Too much inflation can erode consumer buying power, while too little can lead to stagnation.

An unexpected phenomenon is sometimes observed, where the inflation rate does not rise despite a decrease in unemployment. This can suggest that other factors are influencing price levels, such as technological advancements, global trade dynamics, or changes in monetary policy. The inflation rate, when it remains below a targeted level for an extended period, may indicate that the economy has room to grow without generating excessive price pressures, which was the case in Lael Brainard's observation for 58 straight months.

Unemployment Rate

The unemployment rate calculates the percentage of the labor force that is jobless and actively seeking employment. As Lael Brainard noted, a significant decrease in the unemployment rate usually suggests economic growth and a tightening labor market, which can lead to wage increases and, consequently, higher inflation.

However, if this expected increase in inflation does not occur—depicting a flatter Phillips curve—it indicates that the relationship between unemployment and inflation is not as straightforward. It emphasizes the role of various factors, such as labor market dynamics, underemployment, and the participation rate, in influencing unemployment figures without directly leading to inflationary pressures.

Economic Relationships

Economic relationships, like the one described by the Phillips curve, are fundamental tools for understanding how different economic indicators interact with one another. The Phillips curve, in particular, focuses on the tradeoff between inflation and unemployment. A flatter Phillips curve suggests that this relationship may not be as predictable as once thought.

Various economic factors, including fiscal and monetary policy, supply chains, consumer expectations, and external shocks, can influence these relationships. The disconnect highlighted by Brainard's observation may prompt economists to explore more complex models that account for a broader range of variables and their impact on the economy.

Federal Reserve

The Federal Reserve, often referred to as 'the Fed', is the central bank of the United States. It plays a crucial role in shaping monetary policy and managing economic stability. One of its primary objectives is to maintain low unemployment and stable inflation—two key aspects highlighted in the Phillips curve relationship.

In the context of Brainard's observation, the Fed's response to a flatter Phillips curve suggests the need to reassess tactics, possibly by exploring alternative measures alongside traditional interest rate adjustments to achieve its dual mandate. Their challenge is to determine the suitable levers of monetary policy that can keep inflation on target without stifiling economic growth, in an ever-evolving economic landscape.