RDP 2021-09: Is the Phillips Curve Still a Curve? Evidence from the Regions 9. Conclusion

Understanding the nature of the Phillips curve relationship at very low rates of unemployment is of first-order importance to the RBA, particularly at the current juncture with a central forecast for the unemployment rate to fall to a four-decade low over the next few years (RBA 2021b). The lack of historical experience of very low unemployment rates means that studying local labour markets in Australia is a fruitful way of understanding the nature of the Phillips curve at low rates of unemployment. Regional data provides richer variation in inflation and unemployment rates, allowing for more accurate estimation of the slope of the Phillips curve at unemployment rates rarely seen in the aggregate data.

The main finding of this paper is that the Phillips curve is indeed a curve, rather than a straight line. This is consistent with the earlier work by Debelle and Vickery (1997) and findings in the international literature. The Phillips curve is a lot steeper when the unemployment rate is very low, and flatter when there is more spare capacity. Our estimates suggest that the wage Phillips curve is around three times steeper when the unemployment rate is below 4 per cent than it is when it is above 5½ per cent. At even higher rates of unemployment, the wage Phillips curve is almost completely horizontal.

Our estimates of the slope and convexity of the Phillips curve are remarkably close to those from the RBA's current models using the Debelle and Vickery specification. However, at very low rates of unemployment – that is, below 3½ per cent – our estimates suggest that wages growth may not accelerate to the same extent as implied by the RBA's published aggregate Phillips curve models. As such, caution should be exercised when interpreting forecasts and scenarios that reach these very low levels. Reflecting these findings, the forecast scenarios for wage and price inflation presented in RBA (2021b) were constructed using a relationship with a degree of curvature in between that implied by the Debelle and Vickery (1997) functional form and our regional estimates.

Another important finding from our analysis is that there is no evidence that estimates of the wage Phillips curve for Australia are contaminated by the types of biases that have been found to matter in the US literature. However, an important qualifier here is that we have only explored these biases for the wage Phillips curve, and only for the wage Phillips curve estimated over an inflation-targeting period. It's possible that these issues become more pertinent when using a longer historical sample or when modelling price inflation, which in theory is more affected by endogeneity. Although reliable CPI data are not available at the local labour market level, future work could extend our analysis using city-level CPI data to further examine these issues. Although city-level data provide less cross-sectional variation, they are available over a longer time period, making them more suited to analysing the impact of monetary policy regime change on the slope of the Phillips curve. Preliminary analysis using these price data yields qualitatively similar results to those described above for the wage Phillips curve and provides tentative evidence that the slope of the regional price Phillips curve has not changed significantly following the introduction of inflation targeting.

Our paper should not be the final word on these issues for Australia. In addition to studying other measures of wage and price inflation and different historical samples, future research could also turn to exploring some of issues that we have not fully resolved. Notably, how can we account for the fact that some wages are set at the national or international level in these regional approaches? And, is regional labour migration something that may influence the results and in what way? Emerging data sources, such a linked employee–employer data, could be particularly useful for this.

Another useful exercise for future work would be to translate our partial equilibrium analysis into a broader setting by taking our estimate of the slope of the wage Phillips curve and using it in a model with a monetary policy rule (or some other form of endogenous monetary policy). In that model one could then trace out more completely the relationship between unemployment, wages and inflation.