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A Funeral for the Phillips Curve

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I absolutely abhor platitudes, not just because they are boring by nature but because many are simply false. One common platitude held by economists is that a silver lining to this period of escalating unemployment (6.8% as reported by today's non-farm payroll report) is that inflation must moderate. Unfortunately, economics is not immune to the practice of accepting what is purported to be "common knowledge" as gospel truth. A perfect example of this is the theory of the Phillips Curve.

The basic tenet of the theory is that high rates of unemployment bring about low rates of inflation. Conversely, lower rates of unemployment engender higher rates of inflation. The false reasoning arises from the belief that employment rates dictate demand in the economy and thus directly affect inflation rates.

Just last week the Wall Street Journal's chief economics correspondent John Hilsenrath reported a rule of thumb in economics is that for every 1% higher in unemployment rates than the long term average of 5% there is downward pressure on inflation of .3%. Doesn't that sound precise? He went on to explain that this is because people who become unemployed create slack in the economy which brings about deflation.

Economics is part science and part philosophy. But the Phillips Curve theory stands up to neither. Looking back since World War II, we find the data do not support a correlation between employment rates and inflation. The highest rate in unemployment (10.8%) occurred in November of 1982. At that time Consumer Price Inflation was at 4.59%. The lowest rate of unemployment (3.8%) occurred in April of 2000. At that time the C.P.I. registered just 3.7%, so contrary to the popular theory, inflation was actually lower during the lowest period of unemployment than it was during the time of highest unemployment.

Taking a look from the standpoint of inflation, we see no apologies for the theory here either. Consumer Price Inflation hit an all time high of 14.76% in March of 1980. According to theory we should expect to see a very low rate of unemployment. In fact, we see the rate was 6.3%--historically higher than the average of 5%. Later, inflation hit a low of 1.07% during June of 2002. The Phillips Curve suggests that unemployment rates should have been historically quite high but at that time, the rate of unemployment was 5.8%--slightly higher than the historic average and far below the high water mark of 10.8%.

The Phillips Curve doesn't hold up to historical data nor as a matter of philosophy. That's because inflation is a monetary phenomenon and during times of government intervention-like today-excess money supply created by the Federal Reserve in order to combat recession has led to inflation. When people lose their jobs the amount of goods and services in an economy shrinks. In that case, excess money supply loses its buying power and prices rise. Conversely, during a robust job market more goods and services are available to soak up increased money supply. Investors who are banking for a silver lining to this recession may be disappointed by both a continued increase in the unemployment rate, yet stubbornly high inflation.

Michael Pento is a Senior Market Strategist with Delta Global Advisors and a contributor to greenfaucet.com