Why the Phillips curve could decide your financial future

The Phillips curve is back in business.

At first glance, the curve may seem like an anachronism, or merely a piece of economic arcana. After all, it does date back to 1958.

In addition, you may be wondering what on earth I’m talking about.

But in the light of Tuesday’s words from new US Fed boss Jay Powell – and the subsequent falls in stock prices – today I’ll explain what the Phillips curve is. And why it could be key to your financial future…

History lesson

When I was at school – many years ago – those two words were enough to give me the jitters. So I’d understand if you switched off at this point.

Please bear with me for a moment, though. This won’t take long.

The Phillips curve was developed by New Zealand economist William Phillips MBE. He spent much of his academic career at the LSE, becoming a professor there in 1958. And while there’s some opaque stuff about ‘output gaps’, his idea is very basic. It states that unemployment and inflation have an inverse relationship. In other words, if dole queues lengthen, down comes the inflation rate – and vice versa.

As I say, simples! But you probably noticed a weasel word in the above paragraph.

Yes, that’s it. Economist. When one of these proposes a new theory, the rest of the tribe spends many years trying to disprove it.

And so it’s been with the Phillips curve. Economists are still arguing the toss about it. Some say that the concept has been disproven by year of stagflation – that’s when consumers get crushed by both economic stagnation and inflation – while others consider that it’s still very relevant to the world today.

That debate has even continued up to the last month. At the US Federal Reserve, no less. And the Fed’s latest view of the Phillips curve isn’t particularly favourable.

Not easy to discern empirically” and “diminished noticeably in recent years” are two of its rather disparaging comments. Though there’s an admission that “some research” believes there might be something in the Phillips analysis after all.

Was this a reference to one of their own? Because San Francisco Fed boss John Williams isn’t singing off the same hymn sheet.

Earlier this month, he said that the Phillips curve is ‘alive and will soon be kicking’.

Why is this so important right now?

That’s because one aspect of the Curve is at an extreme.

US wages are rising again

America’s unemployment rate is now at a 17-year low of 4.1%. After years in the doldrums, US wage rates are finally increasing again. The year-on-year change in the 3-month average of weekly earnings is rising at 2.9%. That’s up from just 2% annualised growth a year ago.

Further, the January US NFIB small business survey implies that the tightening labour market will push wage inflation steadily higher this year, notes Andrew Hunter at Capital Economics.

34% of firms were unable to fill job vacancies in January, up from 31%, which was close to a 17-year high and suggests labour market conditions are every bit as tight as the low unemployment rate implies”, he says. “The net share of firms planning to raise [pay] over the next three months rose to its highest in 29 years. That points to a rise in average hourly earnings growth from the current 2.9% to above 4% over the next 12 months.

It’s true that these indices have been pointing to much faster wage growth for some time, so a sudden surge above 4% looks unlikely. The difference now, however, is that the upward pressure on firms’ labour costs appears to be feeding through into selling prices, with the share of firms reporting higher prices rising steadily over the past year.”

Put another way, it’s the Phillips curve in action. Fewer unemployed = less spare capacity in the economy = higher wages = rising inflation.

US core consumer prices have also already increased at an annualised rate over the last three months of around 2.9%, up from below 0.5% in Spring 2017. The above analysis flags higher inflation on the way.

Fed rate hikes

This hasn’t been missed by the Fed’s new head honcho Jay Powell.

Fast forward to Tuesday and his debut Congressional testimony as Fed Chair.

He was very bullish about how the US is progressing (not too difficult to predict – it’s always nice to be optimistic as you start your new job). But the flipside is that he also pledged to prevent an “overheated economy”.

That’s central banker-speak for exactly what I’ve been talking about today.

And despite that Fed cynicism about the Phillips curve, it indicates more future US interest rate hikes than the markets had been expecting. Hence the S&P 500 index dropping about 2% since Mr Powell’s comments.

These also unsettled bond investors. The yield on US 10-year Treasuries – which drives long-term interest rates all around the world – rose to almost 2.9% (though yesterday it slipped back a touch to 2.86%). But six months ago it was standing at just 2.1%. In the bond world, that’s a major move in such a short timeframe.

Granted, this sharp climb in long-term yields hasn’t solely been due to Phillips curve effects. Donald Trump’s tax cuts – for which read an even-bigger budget deficit than before – have also played their part in making investors more reluctant to lend money to the US government.

But what’s very clear is that America’s bond game has changed as curve effects kick in. All the pressure now seems to be upwards. And that will affect all of us.

Now I’m not anticipating US hyperinflation at this stage. But it wouldn’t take much more of an uptick in America’s consumer price index to freak out the bond market even further than it’s already panicked over the last few months. As a result, global share prices could tumble just as quickly as they previously went up. This is a time to be cautious in your financial planning.

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