Not All Rules Are Working / Breakdown of Phillips Curve Helps to Explain Why Forecasts of Inflation Haven't Come True

Article excerpt

If the rules of economics operated as advertised, the United States would be suffering from inflation today.

But, obviously, the laws do not always work. One in particular - a rule that says inflation goes up when unemployment goes down - seems to have broken down. And that helps to explain why forecasts of higher prices have not come true.

The great expectation through the 1980s, enshrined in college economics textbooks, was this: Inflation would be triggered when unemployment fell below 6 percent, according to a formula known as the Phillips Curve. Last August, the 6 percent barrier was finally breached. But the inflation rate in the first quarter was actually lower than it was last year.

The breakdown of the Phillips Curve, developed by A.W. Phillips of the London School of Economics in the 1950s, does not mean the inflation rate may not soon start to rise from its present, modest annual pace of 3.9 percent. But if it does, it will be for reasons that have nothing to do with unemployment, factors such as brisk consumer spending, the weak dollar and the export boom, hefty factors all, but none with the inflationary push of higher wages.

Wall Street and Washington now read such seldom-discussed guidelines as the employment cost index, average hourly earnings, unit labor costs and union settlements instead of the civilian unemployment rate for signs of rising wages. And all these Labor Department statistics show virtually no movement in the past year.

Of course, employment and inflation are not completely unconnected. No economist would go that far. The unemployment rate is now 5.6 percent, which it reached in February and March, the lowest level since 1979; the April figure, to be announced Friday, is expected to sustain the downward trend. If it doesn't stop sometime, the pool of unemployed workers will become so small that executives, in theory at least, will have to bid up wages to win away workers from other companies. Then, presumably, the executives will raise prices to cover their higher labor costs.

``But no one knows today what the unemployment level is that makes inflation happen,'' said Robert M. Solow of the Massachusetts Institute of Technology, who won last year's Nobel Memorial Prize in Economic Science. ``We should be cautiously moving the rate down to see what will happen.''

Such experimentation would show that the trigger point is between 4 percent and 6 percent unemployment, and probably closer to 6 than to 4, said Professor Lawrence Summers of Harvard.

One beauty of the Phillips Curve was that a so-called trigger rate of unemployment could be calculated and displayed on a chart. The point on the chart just above the trigger was called the natural rate of unemployment: a level that neither pushed up wages and inflation nor pushed them down. …