Ricardo Reis on the Phillips curve
Many economists argue that the way to reduce inflation is to create “slack” in the economy, i.e., somewhat higher unemployment. I believe that’s a mistake. Unemployment is often an unfortunate side effect of reducing inflation, but doesn’t cause lower inflation. David Beckworth recently interviewed Ricardo Reis, who had this to say about the Phillips curve:
[T]he way I understand monetary policy is, whereby tightening monetary policy, a central bank is able to bring inflation down. In the same way that when I go to the doctor with an infection with a bacteria of some kind, antibiotics are the way to kill the bacteria and cure me from that. However, a side effect, and I emphasize, let me say it slowly, a side effect of raising interest rates is that you also cause a recession. You also lead to an increase in unemployment. In the same way that a side effect of taking antibiotics is that they tend to wreak havoc with your gastrointestinal, digestive system.
Note that it is not a channel. It’s not by taking antibiotics and screwing up my intestines that I therefore kill the bacteria. No, no, it’s a side effect. Likewise, raising interest rates lowers inflation and has a side effect of unemployment, but it may not lower unemployment the same way that you may go through a course of antibiotics and be perfectly fine with your gastrointestinal system. So the fact that unemployment has not gone up, does not in any way discredit the way in which monetary policy works, does not pose a puzzle of any kind, because an increase in unemployment following a tightening of monetary policy is not something that has to happen for inflation to fall. It’s something that often happens as a side effect.
This is also how I look at the Phillips curve.
My only quibble is that Reis seems to equate tightening of monetary policy with higher interest rates. That is often the case, but (as with the inflation/unemployment correlation) not always. The tight money policies of 1929-32 and 2008 were associated with sharply falling interest rates. It makes more sense to view rising interest rates as a common side effect of tight money, just as rising unemployment is a side effect that frequently occurs with lower inflation. But just as high unemployment is not the cause of falling inflation, rising interest rates are not the cause of falling inflation. Instead, it is tight money that reduces inflation.
PS. There’s been a great deal of puzzlement about the fact that NGDP growth remains well above trend, despite a dramatic rise in interest rates that began in early 2022. But this should be no surprise, and indeed is almost the norm. For instance, the Fed began sharply raising interest rates in the spring of 2004, and NGDP growth remained at or above trend in 2005, 2006 and 2007. There are similar examples throughout US macroeconomic history:
Generally speaking, interest rates are a somewhat procyclical variable. For instance, they rose almost continuously throughout the 1960s. So there’s no reason to assume that higher rates will be associated with economic weakness. It depends entirely on why interest rates have increased. (Or if you prefer, whether they have risen relative to the natural rate of interest.)