Phillips Curve
The Phillips Curve is an economic model describing an inverse relationship between unemployment and inflation, suggesting that lower unemployment tends to coincide with higher inflation and vice versa — a tradeoff that shaped decades of US monetary policy.
The Phillips Curve originated from research published by New Zealand economist A.W. Phillips in 1958, in which he documented a statistical relationship between wage inflation and unemployment in the United Kingdom spanning nearly a century. The intuition was straightforward: when labor markets are tight, workers have bargaining power, wages rise, and businesses pass those costs to consumers through higher prices. When unemployment is high, wage pressure eases and inflation tends to moderate.
For roughly two decades after its publication, the Phillips Curve served as a practical tool for US policymakers. The Federal Reserve and the White House operated under the assumption that they could choose a point along the curve — accepting a bit more inflation in exchange for lower unemployment, or tolerating higher unemployment to suppress price pressures. This framework informed the activist fiscal and monetary policies of the 1960s.
The stagflation of the 1970s — a simultaneous surge in both unemployment and inflation following the OPEC oil embargo — shattered confidence in the simple Phillips Curve. Economists Milton Friedman and Edmund Phelps had predicted this breakdown even before it occurred, arguing that workers and firms adjust their expectations over time. If people come to expect higher inflation, they demand higher wages preemptively, shifting the curve outward. In the long run, Friedman argued, the curve is vertical at the natural rate of unemployment (also called the NAIRU — Non-Accelerating Inflation Rate of Unemployment), meaning monetary policy cannot permanently lower unemployment below that threshold without generating ever-accelerating inflation.
The 2010s presented another puzzle. Unemployment fell to historically low levels after the recovery from the Great Financial Crisis, yet inflation consistently undershot the Federal Reserve's 2% target. This apparent flattening of the Phillips Curve prompted extensive academic debate. Possible explanations included globalization suppressing goods prices, the rise of e-commerce, anchor effects from credible inflation targeting, and structural changes in labor market bargaining power.
The sharp inflation surge of 2021-2022 reignited interest in the Phillips Curve. As unemployment fell back to pre-pandemic lows and the labor market tightened dramatically, inflation reached its highest level in four decades. This sequence was broadly consistent with at least a short-run Phillips Curve dynamic, though supply-side disruptions and fiscal stimulus complicated clean attribution.
For investors, the Phillips Curve matters because it shapes how the Federal Reserve interprets labor market data in the context of its dual mandate — maximum employment and price stability. A tighter labor market, all else equal, increases the probability of Fed rate hikes, which typically pressures equity valuations (particularly growth stocks) and raises bond yields. Understanding where policymakers believe the economy sits relative to the NAIRU helps frame expectations for monetary policy direction.