There’s a reason why the Reserve Bank has seemed so relaxed about the effect its interest rate hikes might have on people’s jobs – and it’s not because the bank is heartless, cold or even just hell-bent on getting prices to stop surging at all costs.
The RBA’s focus over the past few years has skewed towards softening price growth over protecting jobs despite its “dual mandate”: its equal responsibilities to keep inflation low and stable, and to keep most people in their jobs.
That’s largely because while unemployment has remained near historically low levels, prices have stubbornly continued to rise much faster than the 2 to 3 per cent a year that the bank – and many of us – are comfortable with.
RBA governor Michele Bullock has also repeatedly reminded us that while people losing their jobs – or struggling to find one – is not ideal, higher prices affect everyone, and especially those on lower incomes who spend a larger share of their income just on everyday necessities.
But there’s another reason why the bank has not been as worried as some economists have been about the possibility of people losing their jobs as it lifts interest rates to slow down the economy.
And it comes down to the relationship between inflation and unemployment which RBA deputy governor Andrew Hauser spelled out in a speech this week.
Many of us know the relationship between inflation and unemployment is generally – although not always – inverse.
That is: when unemployment is high, and more people are on stand-by (therefore indicating we have spare capacity in the economy), businesses don’t have to pay as much to attract and keep workers, and they tend to lift their prices more slowly.
And when unemployment is low, meaning we’re running low on workers that businesses can recruit to help boost supply to keep up with demand, prices tend to rise.
You can look at it the other way around as well.
If we try to reduce inflation – by, for example, lifting interest rates – that tends to come with higher unemployment. And when inflation rises – often because our demand for goods and services is stronger than our ability to supply them – unemployment tends to fall because business want to hire more people to pump out the things we want to buy.
But it’s not a clean trade-off. A change in the rate of unemployment won’t always lead to an equal, opposite change in the rate of inflation.
When we map the relationship out on a chart, known as the “Phillips curve”, with inflation on the Y – or vertical – axis and unemployment on the X – or horizontal – axis, it’s not supposed to be a completely straight line from the top left to the bottom right.
While economists like to call all lines (whether straight or rounded) a “curve”, the original Phillips curve is, indeed, meant to be a curve as most of us would recognise it.
Basically, the curve is steeper towards the left: a change in inflation, when it’s relatively high, comes with a much smaller change in unemployment. And the curve is flatter towards the right: inflation remains fairly low, but even a small change is accompanied by a proportionately bigger change in unemployment.
There are a bunch of theories about why this is the case. One, for example, is that wages rarely shrink. So when the economy is weak and wage growth is very sluggish, further economic weakening and higher unemployment has very little room to push wages (one of the main costs for businesses) down any further, and therefore has very little effect on prices.
The rounded Phillips curve helps to explain why our unemployment rate has stayed surprisingly low despite a bunch of interest rate rises aimed at dampening inflation. The economy is still on the steep end of the curve where policies aimed at lowering inflation don’t have much of an effect on unemployment.
While we can’t rely too heavily on single monthly reads of inflation or unemployment – which can jump around for a range of factors and aren’t always accurate – the latest figures, released this week, showed the unemployment rate fell to 4.4 per cent in May despite several interest rate hikes this year.
Unemployment over the past four years has, without a doubt, generally moved higher, but it’s done so much more slowly than we might have expected – and remains lower than the 5 to 6 per cent range we saw for much of the past two decades.
As Hauser points out, the Phillips curve also helps to explain why, during the pandemic, inflation around the world leapt “sharply and unexpectedly upwards” as unemployment dropped to very low levels. We were, again, on the steep end of the curve where inflation moves more dramatically than unemployment.
But how did we lose sight of the fact that the curve is … well, curved?
The flattening out of the curve by economists happened, Hauser explains, because the relatively stable economic conditions after the inflation surge of the 1970s seemed to suggest the Phillips curve was straighter than its inventor had thought back in the 1950s: inflation and unemployment were at a place where both were moving by similar amounts.
It was also because many economists, who were increasingly using mathematical equations to analyse the world, thought straight – or “linear” – relationships were easier to plug into their calculations.
But this meant that as we came out of the pandemic, a lot of economists were caught off guard by the sudden surge in inflation: that relatively straight Phillips curve they liked using wasn’t the right fit.
With the government and bank both revving up the economy through higher spending and lower interest rates (and with unemployment at very low levels), the original, rounded Phillips curve would have more accurately predicted what ended up happening: a big surge in inflation.
But what does this all mean for the Reserve Bank and monetary policy?
Well, put simply, if the bank believes the Phillips curve is more rounded than straight, and that we’re on the steeper part of it – where inflation is relatively high and unemployment is relatively low – it is more likely to want to get on the front foot by ramping up interest rates, and less likely to be worried about how much that might worsen unemployment.
The good news about being on the steeper end of the curve is that any steps the bank takes to reduce inflation – for example, by ramping up interest rates – should have a proportionately smaller effect on unemployment compared to inflation. Raising interest rates and reducing demand should bring inflation down without kicking too many people out of work.
Of course, as Hauser notes, the bank – and policymakers more broadly – have to remain humble. It’s nearly impossible to know exactly where the economy is positioned on the Phillips curve at any point in time and things are constantly changing.
We also still want – as much as possible – to preserve the big “win” we’ve had with historically low unemployment as we try to get inflation back down. Getting too excited and ramping interest rates up too quickly, or by too much, can still lead to unnecessarily high unemployment – especially if the bank misjudges exactly where we are on the Phillips Curve.
And as with all economic models and charts aimed at simplifying the world, how things play out is never quite as neat or predictable as the lines – whether straight or curved – might suggest. Understanding it, however, helps us peer into the mind of the Reserve Bank as it tries to steer us away from high inflation while keeping as many of us as possible in our jobs.
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Millie Muroi is the economics writer at The Sydney Morning Herald and The Age. She was formerly an economics correspondent based in Canberra’s Press Gallery and the banking writer based in Sydney.Connect via X or email.From our partners
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