Axel A Weber: A central banker's interest in Phillips curves
Speech by Professor Axel A Weber, President of the Deutsche Bundesbank, at the Symposium on
"The Phillips Curve and the Natural Rate of Unemployment" at the Kiel Institute for the World
Economy, Kiel, 3 June 2007.
* * *
1 Introduction
Ladies and gentlemen, dear Professor Snower
It is both a pleasure and honour for me to address such a distinguished audience. The organisers
have to be congratulated on bringing together an impressive number of outstanding researchers to
exchange views on one of the most relevant macroeconomic issues. Please let me say right at the
outset that I shall be speaking about monetary policy and the Phillips curve in general terms. In
particular, owing to the rules of the Governing Council which will be meeting in Frankfurt next
Wednesday, I shall not be dealing with the current stance of monetary policy in the euro area in my
following remarks.
The primary objective of the Eurosystem's monetary policy is to maintain price stability. Only when this
goal is achieved is there room for monetary policy to support the general economic policies in the euro
area. Given our focus on price stability, it is clear that a thorough understanding of the
inflationgenerating process and inflation dynamics is of the utmost importance for the Governing Council in
deciding on short-term interest rates.
As the Phillips curve is the building block of inflation dynamics in many macroeconomic models, a
policymaker's interest in Phillips curves would appear to be self-evident. So, on the one hand, with
regard to the title of my speech today - "A central banker's interest in Phillips curves" - one might
wonder whether such an interest is debatable at all. On the other hand, the Phillips curve concept has
undergone massive shifts over the past decades. The starting point was the seemingly stable
consensus of the 1960s that there is a lasting option for the government authorities to increase
employment by pursuing an inflationary policy. But one should always be suspicious about the stability
of a consensus reached in the macroeconomists' profession. This was true in this case as well.
Indeed, economists' belief in the Phillips curve's trade-off was soon shaken. In 1976, the year I started
studying economics at university, Robert Lucas argued that the Phillips curve relationship collapses as
soon as the government tries to exploit it.
The Lucas critique constituted a severe blow to the Phillips curve. By then, the concept had already
been under concerted theoretical attack from the monetarist and New Classical camps for several
years. Furthermore, the initially stable empirical support of the trade-off had broken down during the
stagflation crisis in the 1970s. Accordingly, there were times when the famous dictum of Robert Solow
that "any time seems to be the right time for reflections on the Phillips curve" was not acknowledged
by our profession.
However, in recent years, research on the Phillips curve has experienced a renaissance. About a year
ago, the Economist wrote that "If haircuts and dress styles can come back into fashion, then so can
the Phillips curve." And this weekend's conference clearly proves that the idea of A. W. Phillips is
again of major relevance for macroeconomists and monetary policymakers alike.
However, developments over the past 30 years have dramatically transformed the economic thinking
underlying the Phillips curve. Thanks to the Lucas critique and the earlier contributions of Ned Phelps
and Milton Friedman, we know today that the empirical relationship expressed in the Phillips curve is
not structural, but (inter alia) influenced by expectations and differences in underlying policy regimes.1
Thus, the current theoretical consensus model is markedly different to the original one. Based on solid
microfoundations and rational expectations, the New Keynesian Phillips Curve (NKPC) has taken up
the fierce criticism of New Classical economists. Emphasising, however, stickiness of prices or
information still delivers Keynesian features and allows for real effects of monetary policy in the
shortrun. At the same time, extended versions of the Phillips curve have been the starting point for policy
analysis: The insights of the literature on time-inconsistency, based on an expectations-augmented
Phillips curve, have been well taken by monetary policy makers. Thus, the famous inflation bias poses
much less of a problem today than it did back in the 1980s when Barro and Gordon or Rogoff
popularised the idea.
Being here as the President of the Bundesbank, let me just mention as an aside that there were few
central banks that followed a stability-oriented monetary policy framework early on and which did not
fall into the trap of a crude Phillips curve thinking in times when this concept was still in fashion in
other policy circles. But given that, in the long-run, we are all stability-oriented monetary policymakers,
it is nonetheless legitimate to ask what the Phillips curve concept has to tell us today. The wide and
impressive spectrum of issues covered at this conference makes clear that no one single speech can
hope to find answers to this question. In my following remarks, I would just like to highlight a number of
aspects that I feel to be of importance in my capacity now as a practitioner of monetary policy in the
Eurosystem.
2 The Phillips curve in monetary policy research
2.1 Monetary policy design and challenges in a low-inflation environment
As a starting point, let me go into slightly more detail concerning the lessons learnt over the past few
decades. It is indeed the case that various institutional changes in monetary policymaking can be
traced back to research on the Phillips curve. And I would like to argue that, in a period of low and
stable inflation, these achievements are not merely of historical interest. On the contrary: In my view,
what is key is the insight that most of the credit for the beneficial inflation climate worldwide is due to
monetary policy having - sometimes painfully - learnt the lessons of the past, especially those related
to the Phillips curve. And, as success breeds complacency, it is vital that these lessons are not
forgotten.
This is more than the usual claim of a cautious central banker as, in my view, there is also some risk
that the current environment of low and stable inflation rates might lead us to some mistaken beliefs
about policy implications. And such wrong-headed policy advice might be inferred from a too naïve
belief in that policy could exploit the relationship expressed in (reduced form) Phillips curves. The
contributions of Lucas and Kydland and Prescott initiated fruitful research on the optimal design of
central banks. To name just a few of the subsequent fundamental advances: The key role of inflation
expectations and therefore the key role of credibility in monetary policy. For these the central issues
are the overriding importance of central bank independence, the investment in a "good reputation" by
combating inflation, as well as the potential benefit of legislated monetary policy rules.
Lucas had raised serious doubts about the validity of the then popular macroeconomic models that
were not based on a firm microeconomic underpinning. His call was answered by a wide array of
research building on microfounded equilibrium models with rational expectations. In academia and in
central banks, the New Keynesian dynamic stochastic general equilibrium framework, which includes
an expectations-augmented Phillips curve, now provides a workhorse model for monetary policy
analysis. The policy advice offered by this framework stresses the importance of the management of
private sector expectations even more than the traditional time inconsistency literature. According to
Woodford (2003), "not only do expectations about policy matter, but ... very little else matters." Even if
one does not completely share this view, inflation expectations are undoubtedly a prerequisite for
achieving the primary objective of many central banks nowadays: price stability in the medium term
and also undoubtedly a crucial measure of a central bank's performance and credibility. Inflation
expectations therefore closely link the success of monetary policy to its credibility; and the latter is
supported if the central bank follows a systematic decision-making process, that is a rule-based policy
strategy, and the general public has as clear an understanding of it as possible: in other words,
monetary policy is transparent and communicated effectively.
These advances in monetary policy, especially the anchoring of inflation expectations, have been the
main driving forces for globally declining inflation rates over the past few decades. A more solid
anchoring of inflation expectations at lower levels than in the past as well as the Eurosystem's
transparency about its policy objectives has also been crucial for the fall in inflation persistence in the
euro area which has been documented by the Eurosystem's Inflation Persistence Network (IPN). The
empirical results of the IPN are based on a new dataset in which national micro data were a key
ingredient. By incorporating real wage rigidities into a New Keynesian Phillips curve, the network also
demonstrates that inflation persistence in the euro area (moderate as it is) is partly generated by
developments in the labour market. I am therefore looking forward to the research results of the IPN's
springoff - the Eurosystem's Wage Dynamic Network.
But back to the original subject: The successful anchoring of inflation expectations and the more
effective monetary policy response to inflationary shocks will both show up in a flattened Phillips curve
when it is estimated in reduced form. This is, in fact, an application of Goodhart's Law: For example,
once monetary policy is responding more effectively to inflationary pressures due to changes in
capacity utilisation, the output gap will empirically lose the information content that has qualified it to
play the role of a leading indicator. Just as a side remark: When it comes to evaluating ex-post the
information content of various indicators in forecasting exercises, Goodhart's law is, of course, not only
relevant for the real economic indicators, but also for monetary ones.
The empirical evidence of a flatter Phillips curve is a phenomenon that has been documented for
several economies, including the United States and the euro area (see, for instance, BIS (2006)). But
as also stated by Mishkin (2007), the main reason for this is arguably monetary policy having been
more successful in stabilising both inflation and output. And here is the point where estimated Phillips
curves may end up in misguided policy advice when the monetary policy reaction and its effects are
not properly taken into account.
1) The empirical result that inflation is less responsive to economic shocks and that inflation
persistence has lowered could lead monetary policy to be too complacent when it comes to
the appropriate response to economic shocks.
2) The empirical result of a flatter Phillips curve implies a seemingly higher sacrifice ratio.
Accordingly, the impression that a given reduction in inflation is more costly in terms of
output may lead policymakers to be more reluctant to respond to inflationary pressures.
But the important point to take into account is that if the dominant structural factors for a flatter Phillips
curve lie on the side of a more stability-oriented monetary policy in the past, these policy implications
may mistakenly induce too lax a monetary policy today. This opens up the possibility of inflation
expectations becoming less well anchored and, once this scenario materialises the task of monetary
policy becomes much more difficult.
2.2 Inflation dynamics and globalisation
It is thus of vital importance for policymakers to draw the right conclusions from the empirical fact that
Phillips curves have changed. I have argued that the main reason is likely to be found in a more stable
monetary policy regime in many countries. To be more precise, it might be because increased
credibility of central banks has anchored inflation expectations, thereby also reducing the volatility of
actual inflation. Moreover, lower trend inflation has reduced the frequency of nominal price adjustment.
Additionally, Goodhart's Law might have come into play. Apart from this chain of reasoning, though,
there might be complementary explanations for the decreased cyclical responsiveness of inflation.
As the flattening of the Phillips curve appears to be a global phenomenon, it is often argued that part
of the change in inflation dynamics can be ascribed to the surge in international competition. This is
supported by preliminary Bundesbank findings (Gadzinski/Hoffmann (2007)) suggesting that trade
openness negatively affects the slope of the Phillips curve in most of the G-7 countries.
Globalisation may enter the traditional Phillips curve by affecting the wage and price-setting behaviour
of households and firms, the extent and frequency of price shocks and the responsiveness of domestic
inflation rather to slack in the global economy than to the domestic output gap. With regard to the
labour market, one might believe that globalisation has weakened the bargaining power of trade
unions because firms have easier access to labour supply in low-cost countries. The recent wage
policy moderation in Germany is a case in point. Similarly, it can be argued that globalisation has
curtailed the market power of domestic firms, thereby pushing down their mark-ups. For Germany,
however, this price-setting effect must have been weaker than the wage-setting effect. After all, profit
margins have been at rather elevated levels in recent years.
In addition to changes in the price and wage-setting behaviour, globalisation may influence the Phillips
curve through other channels as well. It is frequently stated that global competition puts downward
pressure on the prices of imported (labour-intensive) goods. But that is just one side of the coin: At the
same time, globalisation has boosted the prices of other commodities, especially raw materials and
energy. The overall effect of both channels on inflation is uncertain. But taking the energy and raw
material markets into the picture makes clear that the popular view of the price-dampening effects of
globalisation has to be qualified. Moreover, even if the dampening price effects were dominating at the
moment we should not forget that, in the end, it is monetary policy that determines the trend rate of
inflation. Globalisation will ultimately only influence relative prices, not absolute price levels.
Finally, some have proposed extending the domestic Phillips curves by adding a proxy of global
economic slack. A recent BIS study (Borio/Filardo (2007)) finds empirical evidence in support of the
assumption that economies have become more sensitive to changes in global factors. However, the
idea is still controversial. In particular, the robustness of the preliminary estimates has been
challenged (Bernanke (2007), Ihrig et al (2007)). Irrespective of the empirical underpinning, there are
serious practical problems with including global economic slack in the day-to-day decision-making
process, not least because the task of finding a meaningful measure of global slack seems daunting.
In the light of all these arguments, how strong is the impact of globalisation on domestic inflation
dynamics - as opposed to that of an improved conduct of monetary policy? To my mind, globalisation
has arguably had some visible effect, but its strength does not live up to popular expectations.
Nonetheless, the effects of globalisation are an issue for central bankers be it because of increased
model, data and parameter uncertainty, or, more generally, because the flattening of the
inflationactivity trade-off is more of a double-edged sword than a clear-cut blessing. It should suffice to say
that, in the Eurosystem, we understand that the currently low inflation levels do not allow for
complacency on our part. Instead, we will continue to do our utmost in order to keep long-run inflation
expectations solidly anchored.
2.3 New Keynesian models and money
The New Keynesian paradigm at its current stage leaves no role for monetary variables in the inflation
process. In its standard form, it does not allow for an active role for monetary indicators in monetary
policymaking, either as an important variable in the monetary transmission process, or as an indicator
of future inflation.
Does that really mean that money no longer matters - and that it should not matter for monetary
policy? No, clearly not. Firstly, from an empirical point of view, there is plenty of evidence that
monetary aggregates contain valuable information about risks to long-run price stability and the
monetary transmission process. Our own research (Schumacher/Scharnagl (2007)) shows that
monetary variables help predict future inflation over and above the information content of economic
factors included in traditional Phillips curves. Additionally, recent studies (Greiber/Setzer (2007))
support the assessment that the recent surge in house prices and loose monetary conditions are
related phenomena. Significant bidirectional links between money and housing can be identified for
both the euro area and the USA. This proves that integrating money into our analytical framework
delivers important and indispensable insights for monetary policy.
Secondly, from a modelling perspective, the diagnosis of the "irrelevance of money" relies on a
number of simplifying assumptions. Relaxing one or more of these assumptions can restore a more
meaningful role to money even in this model framework. For instance, Christiano, Motto and Rostagno
(2007) extend the basic New Keynesian model by including various measures of money and credit.
They thereby achieve a rather detailed and more realistic description of financial markets and the
transmission process. In addition, acknowledging model uncertainty and the quest for a robust policy
framework, it can be shown that taking monetary factors into account may lead to more desirable
outcomes compared with a purely New Keynesian framework (Kilponen/Leitemo (2007)). And it is
exactly the need for a more robust framework in the face of uncertainty that is the main motivation for
the Eurosystem's two-pillar approach. By the way: Even many of those central banks which would
label themselves as pure inflation targeters, e.g. the Bank of England, have put monetary indicators
more to the heart of their monetary policy analysis framework in recent years.
Integrating monetary and financial factors into the current New Keynesian paradigm is a fairly recent
development in modelling which have only just begun to be incorporated into the present vintage of
DSGE models. Progress on these lines would be highly welcome from a policymaker's point of view.
But, on the basis of the evidence just mentioned, it would be unwise to discard monetary analysis -
especially now that we find ourselves in a period in which asset prices and liquidity are at a high level
and ample on an unprecedented scale worldwide.
3 Concluding remarks
Conferences like this one, which bring together academics and policymakers, serve as a useful
reminder that the challenges to our respective professions have not become less. On the contrary, the
challenges are likely to have increased since monetary policymaking is confronted with many forms of
uncertainty. Research on the Phillips curve is an excellent example of academic work being of interest
far beyond academia itself. The findings of Lucas, Kydland, Prescott, Woodford and many others also
shape our every-day decision-making process - and we central bankers continuously seek such
advice.
So, let us continue our cooperation in a mutually beneficial exchange of views for the public good that
we aim to achieve: price stability, that is low and stable inflation. This is admittedly the best
contribution monetary policy can make to fostering long-run sustainable growth and job creation.
Thank you for your attention.
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