The Phillips curve shows the relationship between wage inflation and unemployment. There is much debate about the strength of this relationship or, indeed, whether it has broken down completely. It is usually plotted as a scattergram but a clear picture emerges if the dots are joined up, as in AW Phillips’ original 1958 article. In chart 6, the dark blue segment relates to economic downturns and recessions when unemployment is rising. The upswing part of the cycle, when unemployment is falling, is plotted in light blue. The dark segment is clearly steeper than the lighter segment. This suggests that inflationary pressures emerge relatively slowly in economic upswings but diminish rapidly in downturns.
Offsetting these concerns, however, is a benign inflationary picture, which is, in part, a consequence of the way in which intangibles have alleviated capacity constraints. This suggests that, rather than suffering an outright contraction, the US will only experience a modest slowdown in its next downturn.
The charts indicate that if the downturn is sufficient to raise unemployment – not our core view over the next year or so – wage inflation would decline, allowing the Fed to respond quickly. This would reduce the risk of a severe recession.