The relationship between jobs and inflation is changing

The relationship between jobs and inflation is changing

At the risk of great oversimplification, the Phillips curve holds that there is a trade-off between inflation and unemployment in an economy. The idea is that lower unemployment will act as a catalyst for greater economic activity, leading to more wage inflation and eventually higher prices. Thus, there’s an inverse relationship between unemployment and inflation. During the 1970’s when the US experienced stagflation, a condition where high inflation is accompanied by low economic activity, the model appeared to breakdown. Subsequent action by then Fed Chair, Paul Volker, appeared to restore the model’s credibility and cemented its use by the Federal Reserve to achieve their dual mandate of contained inflation and full employment.

During Fed Chair Jerome Powell’s testimony last week, Democratic Representative Alexandria Ocasio-Cortez questioned if the Phillips Curve “is no longer describing what is happening in today’s economy.” The dynamic she is describing is historically low US unemployment combined with underwhelming real wage growth, which has left inflation short of Fed’s 2.0% target. Powell largely agreed with her, suggesting that the relationship between unemployment and inflation has become weaker over time. Larry Kudlow, President Trump’s top economic advisor, has continually argued that the current pace of wage growth wouldn’t meaningfully spur inflation. Surprisingly all three seem to be in agreement, which is obviously great for Trump’s 2020 re-election campaign, if this results in low interest rate setting at the Fed.

Whether or not the Phillips curve has broken down as suggested by Ocasio-Cortez – or if it was just a mirage in the first place – the Fed should cut rates right now. There is no danger that easier policy will spur inflationary pressure and slowing global growth provides sufficient impetus for action.

Bottom line: Stubbornly low inflation argues for looser monetary policy at the Fed and implies US rate convergence with the rest of developed markets and resulting in a weaker Dollar.  Given that US Dollar strength can be viewed as a bar to faster growth this is a welcome prospect for emerging markets.  The powerful contrary argument is that lower rates won’t result in the growth many hope and fiscal policy is needed to make a meaningful impact…we are in that camp.


The week ahead

GBP

As we enter the final week of voting for the country to choose a new Prime Minister, Brexit news is likely to remain scarce. Nonetheless, the UK has a number of data releases to pay close attention to. 

  • Employment figures for the month of May will be released on Tuesday with the unemployment rate expected to remain at historic lows.
  • Inflation prints for June will hit the markets on Wednesday.
  • Retail sales are due on Thursday before a quiet finish to the week on Friday.

USD

During his two-day testimony last week, Jerome Powell made it painfully clear that the Federal Reserve will be delivering an interest-rate cut at the end of this month. The domestic economy may not be suffering enough to warrant monetary stimulus just yet, but global growth risks make an insurance cut inevitable.

  • Released Tuesday, US retail sales is the last headline data release before the Fed’s ‘quiet period’ in the run up to their July meeting.
  • Whole host of Fed members speaking throughout the week. Williams (Mon & Thurs); Bowman, Powell and Evans (Tues); Bullard and Rosengren (Fri).
  • Other notable releases include the Philly Fed Manufacturing Index on Thursday and University of Michigan Consumer Sentiment on Friday.

EUR

We’ve got a data-light week coming up for the Eurozone, so any news coming out of the European Central Bank on forthcoming monetary policy will remain in focus. Both Lane - the chief economist - and Couere - the head of operations - have made the case for a 10bps cut.

  • The ZEW economic sentiment survey measures the level of confidence in the German economic outlook over the next six months. Released Tuesday, it’s expected to project pessimism for the third month in a row in a sign of continued struggles in Europe’s powerhouse economy.