Adrian Orr on New Zealand's Phillips Curve

In macroeconomics, the Phillips Curve (named after the New Zealand economist Bill Phillips) depicts the relationship between inflation and unemployment. In the traditional macroeconomic textbook view, this relationship is downward sloping: for a given set of government policy settings and consumers' expectations about future inflation, lower unemployment is associated with higher inflation. This is shown in the diagram below. Say that the economy starts at some point A, where unemployment is equal to UA and the inflation rate is πA. If unemployment decreases to UB, the economy moves along the Phillips Curve in the short run to point B, and inflation increases to πB.

However, there are a couple of things to realise about the Phillips Curve. First, it doesn't show a causal relationship. Lower unemployment doesn't cause higher inflation. This is an empirical correlation that can be explained through other mechanisms. For example, if aggregate demand increases (such as from increased consumer demand, increased investment by businesses, increased government spending, increased exports, and/or decreased imports), then the domestic economy is producing more. To produce more, firms need more workers, so employment increases (and unemployment decreases). This increases the demand for workers, which pushes up wages (or, alternatively, workers have relatively more bargaining power than before, and can demand higher wages). Wage increases lead to increasing costs for firms, who pass on those costs to consumers. This increase in prices leads to higher inflation. So, as you can see, there isn't a direct relationship between inflation and unemployment. It is changes in one or more of the components of aggregate demand that cause changes in both inflation and unemployment, and make them appear to be related.

The second thing to realise about the Phillips Curve is that, in the long run, it is vertical. That is because as firms' costs rise (because of higher wages) they cut back on production and employment. So, in the long run, there is no trade-off between inflation and unemployment. All that happens is that the economy returns to the natural rate of unemployment (which is UA in the diagram above). However, consumers' expectations about future inflation may now have increased, leading them to ask for greater wage increases in future. In that case, the short-run Phillips Curve would move upwards.

That all brings me to this article from the New Zealand Herald earlier this week, which outlines the Reserve Bank governor Adrian Orr's views of the future trajectory for the New Zealand economy:

Orr warned that the interest rate hikes needed to beat inflation would mean higher unemployment.

"Returning to low inflation will, in the near-term, constrain employment growth and lead to a rise in unemployment," he said.

"The actual extent of this trade-off remains unclear, however, given the significant labour shortages globally and the very different means of employment being adopted post-Covid."

"Importantly, it is highly unlikely that we are at maximum sustainable employment if inflation is still high and variable," he said.

As the Reserve Bank increases the Official Cash Rate (OCR), that will reduce aggregate demand (both through reducing consumption, and reducing investment). Orr clearly expects this to have the opposite effect that I described above, decreasing inflation but at the cost of higher unemployment. The Reserve Bank needs to act fast, which is why we've seen a succession of increases in the OCR. The longer the Reserve Bank takes to act, the more that higher inflation will seem like the norm, and the more likely it will be that the economy will end up back at the natural rate of unemployment, but with semi-permanently higher inflation.