The Phillips Curve – Just How Inappropriate a Economic Tool Is It?

Blain’s Morning Porridge 23^rd June 2023:  The Phillips Curve – Just How Inappropriate a Economic Tool Is It?

“In order to save the village, we had to destroy it.”

Phillips Curve economics calls for higher unemployment to calm inflation. Great plan says The Bank and Chancellor while consigning millions of UK citizens to penury. We need something better than wrecking lives and the economy.

One of my favourite Sci-Fi films is The Fifth Element. There is a practical demonstration of Phillips Curve economics early in the movie when the World President tells the bad guy, Jean-Baptiste Emanuel Zorg, to fire 1 million workers to cool down inflation in the overheating economy – which he does with a disinterested shrug. Brilliant… Zorg could have been Chancellor or Governor of The Bank of England.

If the definition of madness is doing the same thing time and time again, the UK economy is in even more trouble than we think.

Maybe we need to re-think inflation? Changing course halfway through the ship of state sinking is bound to be a dangerous moment in economics because consequences beget consequences. But, we have to do something. The problem is economic orthodoxy – sticking to the idea the sacred Phillips Curve is the only way to address the UK’s unfolding economic meltdown – and both Government and The Bank of England are sticking with it.

The Phillips Curve: over time economists have noted that inflation and unemployment are inversely related: when economic growth is strong, wages rise, with higher employment followed by higher inflation. (Makes sense so far.) Therefore: to bring down inflation, you need higher unemployment to take the pressure off wages. Over the long-run the Phillips Curve is absolutely reliable – except when it isn’t, like during periods of stagflation, last seen in the 1970s/80s, and expected again in the UK in the immediate future.

We will come back to the Phillips Curve in a moment.

Yesterday, and frankly to my surprise, The Bank of England demonstrated its awake by hiking rates by 50 basis points (instead of 25) to 5%. Monetary policy in action. The Bank hopes that chasing down Wednesday’s higher than expected inflation number with a larger than expected rate hike will show everyone just how determined they are to somehow cure the UK’s galloping inflation problem.

Nope. It was reactive. It was an economic “Hans Blix” moment: a monetary policy gesture, like writing a very, very angry letter to say how very, very angry they are that inflation isn’t doing what they told us it would. The Bank is playing catch up, pretending it’s ahead of the game – in reality its mired in economic orthodoxy and as confused as any bystander on how to bring down inflation. Heavy hitting economists are filling the commentariat pages with how Andrew Bailey has been too slow, and how the Bank needs to sack one million people now to control inflation.

The brutal reality is UK Interest rates will top 6% – maybe by the end of this year. Gilts are going to hit 6.5% plus as global confidence in the UK starts to wobble as our economic crisis exceeds problems experience elsewhere. (Sterling actually slid y’day – sure sign of trouble ahead.) UK Mortgage Rates – currently crucifying refinancing homeowners at 6% – could top 7-8% as the banks start to feel the pain of a crashing housing market. (That could be an interesting moment; government supporting the banks with TBTF bail-outs even as homeowners are repossessed?)

The Bank’s answer is again to tell consumers to stop demanding higher wages, and to plead with business to stop hiking prices. They ain’t going to listen because many of them are already in desperate financial extremis – and its entirely rational for workers to seek higher pay, and for companies to increase prices as the cost of materials rise. The problem with the Phillips Curve is it does not account for real facts and economic behaviours. Its just a oft-observed relationship – its not a golden rule.

It’s even worse on the fiscal side of the equation. Politically, the Conservative Party (notionally running the country when not trying to politically destroy each other) is a-dither – increasingly aware it’s on course to the worst economic crisis in UK financial history with the imminent threat of galloping stagflation, a crashing housing market, collapsing confidence, and the very real threat the UK’s “Virtuous Sovereign Trinity” of Stable Sterling, a Sustainable Gilts market and Political Competency could be utterly lost as global markets lose confidence in the UK. That is a very real and tangible danger. Welcome to Argentina off the coast of Yoorp.

Prime minister Rishi Sunak has pinned his future to the twin policies of looking credible (which he does tolerably well), and his promise to bring down inflation. (He promised some other random 4 things – but they are immaterial.) Telling inflation to fall is King Canute like – you can only make the sea turn back after the tide has topped. To make inflation fall – you need to do something. Labour leader Sir Keir Starmer’s joke about Sunak’s “keen interest in the California mortgage market” was telling.

The Chancellor of the Exchequer, Jeremy Hunt, has told us the only way to solve this is for The Bank to accept the inevitability of recession and engineer a Phillips Curve shift by creating unemployment. The Chancellor believes economic frailty and job losses will stop companies hiking prices and scare workers into accepting lower wages. Really…?

Stop for a moment, but…. Real UK wages have being falling since 2005. Workers earn less today than they did during the last millennium. For the last 13 years austerity spending has cut every single imaginable service leaving the nation less well educated, less well defended, more vulnerable to ill-health with decaying infrastructure. Our greatest achievement is apparently Brexit… Taxes have increased, tertiary education and childcare costs are the highest in Europe, and this week the UK’s debt to GDP ratio rise above 100% for the first time since 1960. Wealth inequality has dramatically widened. Yep, Austerity politics really delivered..

And folk voted for a government that achieved all that..? I admit that I did. And now the government that has demonstrated such competency wants to engineer a crushing recession to deliver on Rishi’s promise to get inflation down by cutting wages?

There are 3 million home-owning households with mortgages in UK either in the extreme risk category (no savings and zero additional discretionary spending capacity) or at risk (good jobs, dual incomes, but limited resources and limited economic resilience). There are a further 6 million lower income households renting – facing double digit increases which will leave them in penury. These are real people with real financial concerns who aren’t married to an Indian billionaire’s daughter.

Meanwhile, the government’s internal policy discussions on taxes are focused on slashing inheritance tax – benefiting the top 3% of the population by allowing them to pass on more of their wealth to their children, allowing them to get on the “ladder”. The rest of the population can sit and wait for the “trickle-down” effects to reach them.

Let’s get back to the Phillips Curve.

In the long-term it works – of course it does. When economies are hot they generate inflation. As they cool, inflation falls. Unemployment cools – painfully. But employment – the livelihoods of working people – should not be an economic tool, a lever to pulled without concern for the very real people impacted by these decisions. Employment and living standards, housing and services should be the objectives of government… not policy optional extras.

In the Short-Run this inflation does not conform to Phillips Curve norms. It came not from an overheated economy, but from an inflation trigger – Ukraine and Energy costs. It comes on the back of 15 years of ultra-low rates and QE distorting the economy to reward holders of financial assets rather than production – growth during that period was lacklustre, hence almost zero inflation (plus deflation from China exports).

Today, neither workers or companies are following Phillips Curve behavioural norms – companies continue to pay up to hire workers because there is a massive labour shortage across all sectors of the economy, while companies face ongoing supply chain issues pushing up prices. That begs the question – is there any point fighting this “different” inflation with conventional tactics?

Perhaps the reason workers are so keen to risk demands for higher wages is because they are genuinely underpaid – thus higher rates (making them poorer) is actually fuelling rather than calming inflation? (Klaxon, Klaxon: economic heresy alert!) No Sh*t Sherlock.

This is not normal. This requires something different. Time to Think Outside the Box. The problem with thinking outside Phillips Curve orthodoxy is that every new idea has consequences that beget further consequences, and some will be inflationary – and every orthodox conventional economist will dismiss anything new.

At the risk of sounding Neo-Keynesian: any new approach to an inflation/social accommodation has to be about who pays and how – and that has all kinds of “dangerous” wealth redistribution connotations. Imagine we could moderate inflation, avoid mass consumer financial crisis, redefine the tax system to pay for national rebuild, solve the housing crisis.. and enable growth? Sounds positive. But it will come with costs, and will be resisted by those who are redistributed from….

It requires imagination to stabilise this crisis- some ideas:

• Bailing out homeowners and renters with tax breaks or subsidies will be a short-term solution before we solve the crisis at the heart of housing – supply, by building enough homes. Such support could be mildly inflationary – but would remove much of the wage inflation impulse.
• Refocusing the tax base to solve inequality would be fair, ethical, and sustainable – but funnily enough I don’t hear the CIOs and CEOs of all the funds that say they are ESG motivated, ethical and sustainable calling for progressive taxation, wealth taxes, and wealth redistribution.
• Engineer a boom in future industries rather than recession: ensuring cash that flowed into financial assets from 2009-2022 during QE is redirected into real economic growth, productivity gains and strategic economic infrastructure in sectors like renewables, digitisation, AI and services by taxing capital gains (without breaking markets) and even dividends, while balancing that with subsidy and capital direction. The problem here is it’s always dangerous because of the distortions and misallocations such policies can create.

These are just a few of the things we need to be talking about… What we can’t do is just blindly keep destroying the economy to save it by doing the same things and hoping outcomes will change…

Five Things to Read This Morning

BBerg              Yellen Sees Lower US Recession Risk, Says Consumer Slowdown Needed

FT                    Central Banks’ battle with inflation enters a new phase of “pain”

FT                    Sterling fails to find boost from Bank of England rate rise

WSJ                 On Wall Street, Lawyers Make More Than Bankers Now

Guardian         “Shock and Awe” interest rate rise leaves Sunak’s cost of living pledge in tatters

Out of time, back to the day job, and have a great weekend

Bill Blain

Strategist – Shard Capital