With all the volatility in the markets and economic data lately I wanted to talk about an economic concept that everyone should keep in mind, the Phillips Curve. The idea here today is to give you a little insight into why the Federal Reserve makes the decisions it does about interest rates and to frame up the Employment Report issued by the Bureau of Labor Statistics this coming Friday.
A quick history lesson. William Phillips was an economist New Zealand born who wrote a pretty important paper in 1958. His paper, The Relationship between Unemployment and the Rate of Change of Money Wages in the United Kingdom 1861–1957 identified an inverse relationship between wage changes and unemployment. After its publishing there were similar relationships found in other countries and eventually the inverse relationship between wages levels (inflation) and unemployment was recognized as a standard.
Now this model is not perfect nor is the correlation and exact science. There are economic events like stagflation, hyperinflation, or hyper unemployment that happen that lay outside of the Phillips Curve’s ability to explain. There is no magic interest rate that the Federal Reserve can set to achieve a perfect balance of tolerable inflation and unemployment. What it does do is give some good insight for making economic decision makers.
Right now the US has had some of the highest levels of unemployment it has seen in a while. Currently before the July 2nd release the last National Unemployment figure per the Bureau of Labor Statistics was 9.7%. In the same thought -interest rates, or the price of borrowing money, has been at historical lows ranging between 0 and .25%. In very oversimplified terms if money is cheap to borrow then firms that produce goods and services can deliver at lower costs of production which eventually means lower costs to consumers. (In perfect competition markets and barring the recent increased barriers to actually getting credit.) That means our discretionary dollars go farther the longer the interest rates stay low. The Federal Reserve’s reasoning behind this is to encourage companies to borrow and work on growing. The faster companies grow and expand the sooner they will need to higher new talent to produce more. So you see, in a very time delayed move, the Federal Reserve is working on getting people employed.
So, in simple terms, when more people are employed ideally they will have more discretionary income to spend and keep demand up. That will in turn continue to spur growth and the Fed will start to tighten its lending purse strings to curb inflation (rising price levels) that go along with increased demand.
That in a nutshell is why the Phillips Curve is still very relevant. When the markets react negatively to the Federal Open Market Committee meetings or when Unemployment numbers are released it’s because investors were hoping to see signs of growth – of companies and the economy growing. Don’t let that get you down though because there are more than just these two factors that can give you insight into financial markets. Definitely consider reading Charles Wheelan’s Naked Economics, he does a great job with unemployment and inflation. I’m actually using this book in my fall session of macro-economics at a local college here in Western Mass.
When you are looking around your office, meetings, and even your community for new small businesses think about the new faces you have or have not started to see. If you notice a few more your company might one of the few that are taking advantage of low borrowing rates and this opportunity for growth.
If you are hungry for more please check out the Bureau of Labor Statistics. They are a wealth of data and definitions. All the stuff I wanted to talk about but didn’t have the room for :).