That darn Phillips curve again

Bank of Canada Governor Tiff Macklem delivered a speech in Toronto today that attempts to set out the Bank's  rationale for tightening policy even as fears of recession mount. There's nothing particularly new, but the speech does make a few things more explicit than they have been up till now.  Unfortunately, that turns out not to be particularly reassuring.

When the economy is operating above maximum sustainable employment, businesses can’t find enough workers to keep up with demand. As a result, prices go up and inflation rises. That’s where we are today.

No, it isn't. The Governor seems to be saying that current inflation is the result of excessively tight labour markets forcing up wages and thereby compelling companies to raise prices -- in other words, a wage-price spiral. That's not what's happening at all. Inflation is largely the result of pandemic-related supply shocks, exacerbated by the impact of the Russian invasion of Ukraine.  Wage gains have been creeping up but remain well below the rate of inflation, rather than pushing it higher.

One thing that Macklem's statement does make clear is that the Bank is fully onboard with the so-called Phillips curve, which nowadays is generally taken to imply there is a direct tradeoff between tight labour markets and inflation. There's one problem with this, even if we are not bothered by the fact that Phillips's paper was written more than sixty years ago. That paper showed a statistical relationship between the unemployment rate and wages, not inflation. It might be reasonable to assume that high wage gains can be curbed by tightening policy and boosting unemployment, but when you have inflation that is almost entirely unrelated to wage gains -- today's situation -- it becomes much harder to see the logic of trying to curb inflation that way. 

Demand is what the Bank influences with interest rate increases. Our analysis suggests that because the labour market is hot and we have a high number of vacant jobs, we can afford to cool the economy without causing the surge in unemployment that we experienced in previous recessions.

Wait, what?  The whole logic of the Bank's recent policy moves surely relies on the Phillips-y idea that cooling the economy from its current condition of excess demand will bring down inflation, in large measure by cooling wage demands. But Macklem seems to be saying that this can be achieved without significantly boosting the unemployment rate. It's not remotely clear how that's supposed to happen. 

Is there anything in the speech that helps us understand what the Bank's next moves might be? Well, there's this: That’s why we have front-loaded our interest rate increases.

At the risk of over-parsing, the use of the past tense "have front loaded" rather than "are front-loading" might be the merest of hints that the Bank is finished with outsized rate hikes and will proceed more cautiously from now on. Given the apparent flimsiness of the Bank's underlying assumptions, however, it's hard to be certain about that.