The Shape of the Phillips Curve Should Worry Markets

Inflation may not be as stable as generally believed, and the bigger risk may be disinflation.

Curves matter in markets.

Photographer: Daniel Berehulak

There’s lots of debate over whether the Phillips curve is broken, but almost none of it centers on the shape of the curve, which may be the more important topic. The Phillips curve, which essentially suggests there is in inverse relationship between unemployment and inflation, has become abnormally vertical in recent years.

The steepness suggests inflation should stay stable to around current rates of unemployment. But the thing is, the unemployment rate has been between 4.3 and 4.7 percent since the spring of 2016 and yet the inflation rate has drifted down to 1.7 percent from 2.7 percent. That implies that inflation may not be as “stable” as generally believed, and that the bigger risk may be disinflation. Stagnant wages, lower energy prices and technological disruption are already causing deflationary trends in core goods and negatively affecting broad inflation expectations.

For markets, a vertical Phillips curve with unstable inflation expectations means real interest rates could start to rise and cause financial conditions to tighten. Such a scenario would be unwelcome as uncertainty in Washington is building.   

U.S. Phillips Curve Over the Last 20 Years

Source: Bloomberg. Inflation is headline CPI (y/y %).

Here’s another disturbing development: Since the Federal Reserve ended its third round of bond purchases, or quantitative easing, in late 2014, real interest rates have decoupled from nominal, or inflation-adjusted, interest rates as bond traders show increasing skepticism about the economy’s potential to get inflation back to 2 percent. The upshot is that if this trend continues, the vertical Phillips curve could begin to flatten and bring about a less friendly environment of low but unstable inflation that could push up real interest rates adversely. 

Nominal and Real Interest Rate Expectations

Source: Bloomberg.

We should also keep an eye on “yield betas,” or the relationship between the change in real rates and the change in nominal yields. Historically, when the yield beta was 1, inflation was range-bound and low, like it is now. When it’s near zero, inflation trends higher, as was the case in February when the headline inflation rate peaked at 2.7 percent.

Since 2010, spikes above 1 have regularly occurred and contributed to new lows in inflation expectations. So, with the yield beta back on the rise, there’s a greater chance that the so-called “reflation trade” anticipated by markets from Donald Trump’s election victory could reverse.    

Yield Beta and Inflation Expectations

Source:Bloomberg. Yield beta = Covariance of 10-year nominal Treasury and 10-year TIPS / variance of 10-year nominal Treasury and 10-year TIPS.

Another distressing trend for riskier assets can be seen in the negative correlation between returns for Treasury Inflation-Protected Securities and those for the S&P 500 Index. A negative correlation has historically coincided with headline inflation running below target and falling, tightening financial conditions beyond what can be justified by equity prices.

TIPS and Equity Return Correlation

Source: Bloomberg. Correlation of Barclays’ 10-year Tips index and S&P index annual return.

As central bankers gather at Jackson Hole, Wyoming, and ponder why inflation has remained stubbornly below target, the vertical Phillips curve should be a top concern. Not only does a vertical curve leave inflation numb to a change in unemployment, but the assumption that inflation expectations are stable is wrong. Markets are pricing an increasing chance that inflation expectations settle at a lower long-term average of 1 percent to 1.5 percent. 

In the 1970s, a vertical Phillips curve explained stagflation because inflation was high and unstable. Today a vertical Phillips curve is about “stallflation,” where inflation is low but markets are pricing inflation as unstable. A direct implication is that central bankers may lose the ability to reflate the economy through financial markets. That’s not a welcome message for those attending at Jackson Hole.   

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