Is The Phillips Curve Dead Or Alive In India? The RBI Attempts An Answer

The Phillips curve, a long followed but debated correlation between inflation and unemployment, has come back into focus in post-pandemic months.

In its original form, the Phillips curve identifies an inverse correlation between unemployment and wage growth. The policy implications of this are that unemployment can be lowered but only at the cost of higher wages. Conversely, wage growth can be lowered only at the cost of higher unemployment.

Put more broadly, the Phillips curve established the inverse relationship between output relative to an economy's potential and inflation. So if actual output is lower than potential, inflation should be under control and vice versa.

While the curve has been debated for years, most recently the correlation came into the question in the months after the pandemic when inflation, including demand-driven core inflation, remained high despite a sharp fall in output.

What does this mean, asks a paper in the Reserve Bank of India's November bulletin.

• Is there sizeable slack in the economy induced by the pandemic, as high frequency indicators suggest?

• Or has the pandemic changed all that, pushing down potential output along with actual output?

• What is the state of the output gap?

• Has the relationship between slack and inflation broken down?

"With core inflation unresponsive to the contraction in the economy, the exploitable trade-off between aggregate demand and core inflation broke down, leaving the conduct of monetary policy in no-man’s land and the very existence of the Phillips curve came into question," the paper said.

In answering these questions, the paper notes that the output gap in India is still negative but is closing fast.

It adds that while the Phillips curve in India "is alive", it's recovering from a period of flattening that has lasted more than six years since 2014. This, the central bank attributed to the introduction of inflation targeting in India, which helped anchor inflation expectations. Inflation expectations can feed into actual wage and price increases and lead to inflation.

The analysis, however, also found that as the output gap becomes positive, inflation tends to rise faster. The paper goes on to show that the output gap in India is still negative but is closing quickly.

"Under current macroeconomic conditions, still weak demand conditions are flattening the Phillips curve in India, providing some manoeuvring room for monetary policy to support the recovery without being hemmed in by demand-driven inflation concerns," the paper concludes.

The paper, which is a view from the RBI's research department, comes ahead of a policy review where the central bank is expected to take stronger steps to unwind monetary policy accommodation. This, however, is likely to come via an increase in the reverse repo rate rather than the benchmark repo rate.

The MPC, which votes on the repo rate, is likely to leave it unchanged as headline inflation remains within the comfort band of 4 (+/-2)%, even though price pressures are now starting to rise.

Retail inflation, the nominal anchor for monetary policy in India, was at 4.5% in October. However, core inflation rose to over 6%. Wholesale inflation data, too, is signaling a build-up of price pressures.