RDP 2021-09: Is the Phillips Curve Still a Curve? Evidence from the Regions 1. Introduction

As the labour market recovers from the effects of the COVID-19 shock, a key policy question facing the Reserve Bank of Australia (RBA) Board is at what point spare capacity in the labour market will be absorbed and, as a result, when will there be a sustained increase in wages growth (Lowe 2021). In other words: how strong is the relationship between unemployment and wages growth (often referred to as the wage Phillips curve), and does the nature of that relationship change as the unemployment rate falls to lower and lower levels?

Despite the importance of this question to the RBA (as an inflation-targeting central bank), the way in which aggregate wages would respond at rates of unemployment below those observed in recent history remains a key source of uncertainty, both in Australia and in other countries. In the Australian case, much of the uncertainty stems from the lack of evidence to draw upon. In the lead up to the global financial crisis (GFC), the unemployment rate declined steadily for a number of years (ultimately falling to a low of 4 per cent) and wages growth rose strongly in response. However, this was the only time over the past four decades the unemployment rate reached such a level (Figure 1).

This paper attempts to overcome this lack of historical experience by examining the relationship between the unemployment rate and wages growth across 291 local labour markets in Australia over the past two decades. In contrast to the national data, a panel of local labour markets provides many more observations on what happens to wages growth when the unemployment rate falls to very low levels. For example, in our dataset, more than one-fifth of all region–year observations have an unemployment rate below 4 per cent.

In examining whether the wage Phillips curve relationship is stronger at lower levels of unemployment, we contribute to a well-established literature on nonlinearities in the Phillips curve. Economists have long believed the Phillips curve to be a curve, rather than a straight line. Indeed, Phillips's (1958) original paper, as well as many introductory textbooks, show the relationship with a steeper slope when the unemployment rate is low and a flatter slope when the unemployment rate is high. This nonlinearity in the inflation–unemployment trade-off has been explicitly incorporated into the RBA's wage and price inflation models since the late 1990s, following a research discussion paper by Debelle and Vickery (1997).^[1]

The question of whether the Phillips curve is a curve rather than a straight line in Australia has not been thoroughly revisited since Debelle and Vickery (1997). We believe that the time has come to re-examine the shape of the Phillips curve and test whether the functional form that underpins the RBA's current suite of Phillips curve models remains suitable. This is particularly important in light of the remarkably strong recovery in the labour market over the past 12 months and the RBA's baseline forecast for an unemployment rate approaching 4 per cent by end 2023 (RBA 2021b).

Using regional data also allows us to overcome the biases that can arise in identifying the slope of the Phillips curve using national data. These biases can arise from the endogenous response of monetary policy to economic conditions or changes in long-run inflation expectations, both of which can hinder identification of the Phillips curve in national time series data. The literature covering the US Phillips curve has demonstrated that it is important to account for these biases, and often exploits regional data to do so (Fitzgerald et al 2020; Hazell et al 2020; McLeay and Tenreyro 2020). Although the recent literature largely deals with the price Phillips curve, the same intuition applies when estimating the wage Phillips curve, which is our focus. A key advantage of using regional data to estimate the Phillips curve is that demand-driven variations in unemployment and wages that are specific to particular regions should be free from the biases that can plague estimates of the Phillips curve. However, using regional data to estimate the Phillips curve does present some challenges, most notably the task of translating regional estimates into aggregate ones.

As a benchmark, we first estimate a linear wage Phillips curve using data from 291 local labour markets over a 20-year period. Our estimates are broadly consistent with previous linear estimates for Australia and elsewhere; when the unemployment rate falls by 1 percentage point, annual wages growth increases by 0.2–0.3 percentage points on average. We then allow the slope of the Phillips curve to vary with the unemployment rate by allowing it to have a series of kinks. We strongly reject the hypothesis that the Phillips curve is a straight line – it is a curve. When the unemployment rate exceeds 7½ per cent, we cannot reject the hypothesis that the Phillips curve is flat. However, we find that the slope of the Phillips curve steepens when the unemployment rate falls below 5½ per cent, and steepens further when the unemployment rate falls below 4 per cent. Importantly, our estimates are stable over time; we find no evidence that the slope or curvature of the wage Phillips curve has changed since 2012 despite the slowdown in wages growth that has occurred since then.

Our estimates of the slope and curvature of the Phillips curve are remarkably similar to those inherent in the RBA's aggregate wage Phillips curve model, suggesting that the nonlinearity assumptions adopted following Debelle and Vickery (1997) remain broadly appropriate. The only meaningful difference emerges at unemployment rates below 3½ per cent, where the RBA's aggregate model assumes a much sharper increase in wages growth and inflation than our estimates based on regional variation.

These findings have important implications for policy. According to the RBA Board (RBA 2021a), the cash rate will not be raised until inflation is sustainably within the 2 to 3 per cent target range. The relationship between unemployment, wages growth and inflation is important for understanding how inflation will evolve. While endogenous policy makes it difficult to extrapolate from regional evidence to draw conclusions about outcomes at the aggregate level, our paper provides evidence as to the underlying relationship between unemployment and wages growth. This relationship is a key component of the broader equilibrium between unemployment, wages growth and inflation, and understanding it is crucial given the RBA's policy objectives.^[2]

Footnotes

Debelle and Vickery showed that, in a horse race, a nonlinear Phillips curve specification outperformed a linear one in several respects. Most importantly, the nonlinear specification generated estimates for the non-accelerating inflation rate of unemployment (NAIRU) that looked more sensible than those from a linear model. Their specification was largely based on that of Debelle and Laxton (1997). [1]

Economic theory suggests that aggregate inflation (in prices and wages) and unemployment outcomes are determined in equilibrium with monetary policy, while the estimates of the Phillips curve at the regional level abstract from the conduct of monetary policy (Fitzgerald et al 2020). As such, using our region-level evidence to directly infer how aggregate wages growth will respond as the unemployment rate declines is only valid, strictly speaking, if monetary policy is completely exogenous. A useful exercise for future research would be to take our estimates of the slope of the wage Phillips curve and use those in a model with a monetary policy rule (or otherwise endogenous monetary policy). In that general equilibrium model you could then trace out the relationship between unemployment, wages, and inflation in a way that is consistent with the regional evidence but also respects the endogeneity issue. [2]