Governments aren’t the only things proving to be less than strong and stable these days. Take the Phillips Curve, which describes the relationship between unemployment and wage growth. As unemployment falls, using up spare capacity in the labour market, it makes intuitive sense that wage growth starts to pick up. Given the key role played by wage growth in economy-wide inflation, central banks look to the Phillips Curve when they set interest rates. Over the past few years, however, the curve has been remarkably flat: unemployment has fallen but pay pressures have remained very subdued. In the UK, the pace of wage growth is similar now to when unemployment peaked in 2011, despite the fact that 2.7 million jobs have been created in the meantime. Unemployment rates in the US, Japan and Germany have also fallen to historic lows without sparking a rapid pick-up in pay pressures.
So why is the Phillips Curve flat? Three explanations spring to mind. First, the move by central banks to inflation-targeting, alongside a prolonged period of subdued inflation, may have “anchored” workers’ inflation expectations at low levels even as labour markets have tightened. Contrast this with the 1970s, when very high rates of inflation and lack of policy-making credibility steepened the Phillips Curve. Back then, workers factored high rates of expected future inflation into pay bargaining, underpinning strong wage growth despite rising unemployment. Second, productivity growth – a key determinant of companies’ ability to reward employees – has been persistently weak. Finally, there are structural reasons behind the flattening of the curve. Technology and globalisation may have weakened workers’ bargaining power. Increased “casualisation” of the labour market may also have played a role. 13.5 million UK workers, accounting for 43% of the labour force, are now self-employed, in part-time or temporary work or on zero-hours contracts. This is an increase of 3.5 million workers since 2000, according to Bank of England estimates. Similar structural trends can be observed in other economies.
Central banks have responded to the flat Phillips Curve by holding interest rates at historically low levels.
So far, central banks have responded to the flat Phillips Curve by holding interest rates at historically low levels. After all, in the absence of an obvious acceleration in wages and prices, why do anything else? But there are signs that some, at least, may be changing their tune. The Bank of England’s Monetary Policy Committee surprised observers recently when three of its eight members voted for an immediate rate rise. European Central Bank (ECB) President Draghi has become more confident about the Eurozone’s prospects, declaring that “deflationary forces have been replaced by reflationary ones”. And at its latest meeting, the US Federal Reserve (Fed) increased interest rates for the second time this year, while maintaining its prediction of another rate rise by end-2017. It also unveiled a detailed plan to begin unwinding its balance sheet in the months ahead. This was despite a run of weak inflation numbers, which the Fed has put down to temporary factors.
How are investors reacting to this apparent change of tone? So far, they have remained fairly sceptical. Following the Fed’s 14 June announcement, the market-implied probability of another rate rise this year remained below 50%. In a sign that the inflation data are weighing on markets’ minds, break-even rates – giving a measure of the inflation rates expected by investors, as implied by the difference between inflation-proof and conventional government bonds – fell sharply. At the same time, the US yield curve flattened. Following Mr Draghi’s comments, bond markets have sold off a little, raising yields, but the moves have so far been modest.
You can hardly blame markets for their caution. After all, the Fed has undershot its inflation target consistently over the past five years. Investors may also be sceptical of Fed Chair Janet Yellen’s assertion that the ‘normal’ Phillips Curve “remains at work”. In their favour, some of the structural reasons for a flat curve – technology, casualisation – appear persistent. However, Ms Yellen can draw on two arguments. First, there is the “give it time” argument: that the official unemployment rate is an imperfect measure of developments in the labour market, and other, broader measures (such as the difficulty that firms report in hiring workers, or the rate at which workers are quitting their jobs) are taking longer to tighten. Second, there is the “just around the corner” argument: if unemployment falls much further, the curve could steepen sharply as the lack of spare resources triggers a sudden burst of wage and price inflation. This is all very well in theory, investors might counter, but for now the reality is that the curve remains stubbornly flat.
So what are the implications for investors? Given the divergence between the Fed and markets, the latter are vulnerable to ‘unexpected’ monetary tightening if central banks’ determination proves stronger than markets currently bargain for. Even if the Fed is wrong on the Phillips Curve, there could be a sting in the tail for investors over the longer term. In a world where labour remains surprisingly cheap, firms have less of an incentive to invest in capital. If future investment trends disappoint, productivity and economies’ growth potential may do the same. As unemployment rates continue to fall, therefore, we should all be watching the curve: remain flat, normalise or steepen?
The article above was previously published on Aberdeen Asset Management’s ‘Thinking Aloud’ blog on 5th July 2017