Hauser: Nonlinear Phillips curve shapes monetary policy
BIS Deputy Governor Andrew Hauser highlighted the critical importance of the nonlinear Phillips curve for monetary policy. Speaking in Melbourne, he noted its resurgence in relevance following the post-Covid inflation surge.
The costly mistake of straight lines
For decades, Phillips' original insight that the inflation-unemployment relationship is nonlinear was neglected, favouring a linear assumption.
This proved a costly mistake when, post-Covid, inflation surged unexpectedly amid near-full employment.
While debate continues on supply and demand factors, the surge of interest in Phillips' findings highlights the need for robust micro-foundations for nonlinearity in macroeconomic models.
Australia, and the RBA, had not forgotten this insight; a seminal paper by Debelle and Vickery, building on IMF work, showed a nonlinear model fitted Australian data better, leading to its inclusion in the RBA's forecasting suite.
However, even these models underestimated the post-Covid inflation pickup, partly due to estimation over periods on the flatter part of the curve and insufficient capture of different nonlinearity sources.
From curve to straight line
Phillips' original curve for the UK definitively showed a nonlinear inverse relationship, with cost pressures rising more rapidly at lower unemployment.
However, later variants by Samuelson and Solow, Friedman, and New Keynesians largely adopted linear forms.
Friedman argued policy trade-offs were an illusion in the long run, leading to a vertical Phillips curve as inflation expectations shifted.
New Keynesians rehabilitated a short-run trade-off, but still with linear assumptions.
This 'ironing-out' occurred due to the 1970s-80s focus on expectations, the stable 'Great Moderation' period, and the ease of integrating linear relationships into models.
This fostered a belief in a flat, linear curve.
Nonlinearity is not a 'nerdy backwater'
Hauser's speech underscores that the Phillips curve's nonlinearity is a first-order concern for monetary policymakers, not a mere technicality.
The post-Covid inflation experience starkly revealed the dangers of assuming a linear relationship, forcing a re-evaluation of long-held models.
Central banks must now deeply understand the curve's precise shape, position, and how it shifts under various conditions to effectively manage inflation and employment.