Michael Ryan on whether fighting inflation always leads to recession

We've just finished teaching the macroeconomics section of ECONS101 for this trimester (which brings our teaching to a close). The last week covers the Phillips Curve - the empirically-observed short-run trade-off between inflation and unemployment. The implication of the Phillips Curve is that if the government wants to reduce inflation, it can do so only at the cost of higher unemployment. And if the government wants to reduce unemployment, it can do so only at the cost of higher inflation.

My colleague Michael Ryan wrote on The Conversation recently on the topic of whether fighting inflation leads to recession. He wrote:

But are reductions in inflation inextricably linked to recessions?

New Zealand’s own economic history, it turns out, can give some guidance on this, and point to the risk factors within the country’s economic outlook...

Since 1961, New Zealand has experienced eight falls in inflation (disinflations) of four percentage points or more. (Disinflation refers to when inflation drops but remains positive, while “deflation” occurs when the inflation rate falls below zero).

This four percentage point drop is required for New Zealand’s inflation to reach the Reserve Bank’s target of 1-3%, down from the 7.3% recorded in the third quarter of 2022...

Then, after looking at New Zealand's history of periods of disinflation since 1960, he concludes that:

The message is a positive one: a fall in inflation does not necessarily have to be associated with a recession.

That was a bit of a relief to me, given that I wrote at the end of 2022 (also in The Conversation) that the Phillips Curve relationship is not causal, but that nevertheless:

...we can probably expect unemployment to move upwards as the Reserve Bank’s inflation battle continues. Not because lower inflation causes higher unemployment, but because worker and consumer expectations take time to reflect the likelihood of lower future inflation due to the Reserve Bank’s actions.

And since workers negotiate only infrequently with employers, there is an inevitable lag between inflation expectations changing and this being reflected in wages. Alas, for ordinary households, there is no quick and easy way out of this situation.

It is good that Michael Ryan and I are not inconsistent with each other! In theory at least, when the Reserve Bank manages to reduce inflation and unemployment is not negatively affected (that is, the economy doesn't enter recession), it's because inflation expectations have adjusted quickly. That is not always the case.

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.