RELAX.We are on a good Phillips curve

Craig Callahan, DBA

April 27, 2015

The Phillips curve (the curve), first presented in 1958 by A. W. H. Phillips, represents the available tradeoff between inflation and unemployment at a given point in time. The hypothetical Phillips curve in the graph on the right is a demonstration of this tradeoff whereby attempts to reduce inflation by slowing the economy would cause unemployment to rise. Or, inversely, stimulating the economy to decrease unemployment could cause inflation to increase. Notice however, the tradeoff is not constant, as the line is not straight. For example, at point A, a reduction in inflation could be accomplished with a minimal increase in unemployment but at point B, a slight reduction in inflation would be very costly in terms of unemployment.

When originally presented, it was hoped that the Phillips curve would persist for very long periods (decades). However, debate in the 1970s proved convincing that any one curve exists for only a short time period (a few years). In other words, the tradeoff between inflation and unemployment may exist in the short-term, but has not been observed over long periods. We believe that at any point in time, the position and shape of the curve is determined by numerous factors such as resources (land, labor and capital) and demand for goods and services, which are functions of demographics. The mobility of resources is a foundation of the free market system and while we have infringed on that mobility through protectionism in some industries, labor unions, subsidies and tariffs, to name just a few, resources do change over time. Thus, ICON believes that the curve and its tradeoff between inflation and unemployment exists in the short run while its shape and position move around over time as resources and demands change.

For a few years in the late 1970s, during a time labeled “stagflation” by economists, unemployment was in the 6% to 8% range with inflation in the 5% to 13% range. The resources and demands at the time dictated a very unpleasant Phillips curve. Now, however, 35 years later with an entirely different mix of land, labor, and capital and different demands for goods and services, we believe the economy faces a much friendlier set of inflation and unemployment combinations. In other words, we believe we are sitting on a very pleasant Phillips curve.

Obviously one does not need to know what a Phillips curve is to be a successful stock and bond investor, but we think it does explain, at least in part, a lot of what has happened during the stock market advance of the last six years. Along the way, some analysts feared an accommodative monetary policy by the Federal Reserve would cause increased inflation, but it hasn’t. Some argued inflation and other factors would cause interest rates to rise, but interest rates have not risen. During the two “European Debt Crises”, there were predictions of a double-dip recession with the usual rise in unemployment, but that didn’t happen. Many forecast that unemployment would not come down during the economic recovery, but so far it has, a trend we expect to continue. We believe we are in a docile, forgiving economic setting and the current blend of land, labor, and capital and demand for goods and services puts us on a friendly Phillips curve.

Gradually declining unemployment and low inflation have been a nice setting for the stock market advance of the last six years. We think that the current mix of resources, demands and demographics have put us on a nice Phillips curve and we believe these conditions can continue for a while.

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