Chart of the Week: Why inflation expectations are key to a US soft landing

Nobel Prize-winning economist Paul Krugman recently set out two possible explanations for the recent benign period of disinflation in the US, which has seen inflation fall sharply with no meaningful increase in unemployment. One explanation he labelled ‘long transitory’. This is the argument that the pick-up in inflation, rather than being monetary in nature, was a consequence of supply bottlenecks. These have now resolved themselves and so inflation is falling sharply. This was Mr Krugman’s preferred explanation, and it largely absolves US policymakers of any responsibility for the substantial overshoot of the inflation target. But Fathom prefers Mr Krugman’s second explanation, which he labelled the ‘non-linear Phillips curve’, and then promptly dismissed. The Phillips curve describes the inverse relationship between the rate of unemployment and the rate of inflation. In a world where the Phillips Curve is non-linear, Mr Krugman argued, the response of inflation to small changes in unemployment becomes much greater when the economy is overheating.

The relationship between US unemployment and inflation is clearly non-linear, as our chart shows, and with good reason: inflation depends not just on the amount of economic slack, represented by the unemployment rate, but also on inflation expectations. As the major economies began to re-open in 2021, there were indeed some supply bottlenecks. These provided the initial impetus that drove US inflation from less than 2% to more than 5% in the first six months of that year. With the Fed seemingly unconcerned, and talking down expectations of a policy tightening, inflation expectations began to rise, and the Phillips curve moved sharply higher. As demand continued to strengthen, fuelled by exceptionally loose monetary and fiscal policy, unemployment continued to fall, pushing inflation even further above target — leading to a further loss in confidence in the Fed’s ability to meet the 2% target, and pushing the Phillips curve higher still. US inflation peaked in June last year, three months after the Fed began to tighten policy. Since then it has fallen sharply, as unemployment has remained low. In our view, this is because the Phillips curve has shifted down, as credibility has been restored. In the past, this kind of adjustment in inflation expectations has almost aways required a recession. This time might just be different. Our central scenario sees the US escape recession, just, but it is a close call.

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The views expressed in this article are the views of the author, not necessarily those of LSEG.

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