Why has the Phillips Curve gone flat?
August 03, 2017
Traditional economic theory would suggest that low unemployment will be associated with relatively high wage inflation - and vice versa - as described in the ‘Phillips Curve’ (named after the economist who first identified this relationship in the 1960s). However, the unemployment rate in the UK now stands at its lowest level since 1975, but wage growth remains low at levels comparable to those seen at the time of the recent unemployment peak in 2011. So has the Phillips Curve relationship broken down? And if so, why?
To explore this further, in our latest UK Economic Outlook report we modelled the relationship between wage growth and unemployment using annual data available from 1971. The UK economy during this period can be characterised by three distinct periods:
- 1971-1992: a period when the UK government struggled to control inflation while unemployment was relatively high and volatile due to three major recessions;
- 1993-2007: a period of relative economic stability in which the UK government switched to inflation targeting from 1993 onwards (with an independent central bank from 1997); and
- 2008-2016: the global financial crisis and its aftermath.
As can be seen from the chart below, the relationship between unemployment and wage growth has become much flatter in the 1993-2007 and 2008-2016 periods than in the 1971-1992 period when a downward-sloping Phillips Curve did seem to be in operation, albeit with considerable variation around the ‘best fit’ line shown in the chart. As well as flattening after 1992, the Phillips Curve has also shifted downwards over time as ‘normal’ levels of nominal wage growth have declined.
A number of factors are likely to be at play in these Phillips Curve shifts, but one key factor is the reduction in the bargaining power of workers. Unionisation of the workforce has fallen from 38% in 1990 to 23% in the middle of 2016 (and considerably lower than this in the private sector), while self-employment and part-time and temporary working have increased. These changes reduce wage bargaining power as firms are able to negotiate with individuals rather than groups, while the increased flexibility of modern work may induce people back into the workforce, restricting upward pressure on wages.
The globalisation of organisations and continuing digitalisation is also a likely contributor to this flattening, as a broader range of work can be completed anywhere in the world, thus lifting the constraints of labour supply in any one country.
Increased migration to the UK from other EU countries since 2004 may also have played some role here in dampening wage growth in response to increased labour demand as it has made labour supply more elastic. Depending on how UK migration policy evolves, this factor may become somewhat less important after Brexit. This could potentially worsen skills shortages in the UK, but might also offer some support for wage growth at the lower end of the labour market (in addition to the effect of planned future increases in the national minimum wage).
For at least the next couple of years, however, the fundamental factors underpinning the flatter, lower Phillips Curve seem likely to remain in place. We therefore expect wage growth to remain relatively subdued over this period, even if unemployment remains at or below current low levels.
 Similar shifts in the Phillips Curve were found in a recent analysis by Andrew Haldane, chief economist at the Bank of England: http://www.bankofengland.co.uk/publications/Pages/speeches/2017/984.aspx