The Reserve Bank of Australia (RBA) is intensifying its focus on the complex relationship between unemployment and inflation, emphasizing the need for nuanced policy responses as it navigates a rapidly changing economic landscape. In a lecture delivered to the Economics Society in Melbourne on Tuesday, RBA Deputy Governor Andrew Hauser revisited the foundational work of economist Bill Phillips, highlighting how the interplay between labor market conditions and inflation is nonlinear and context-dependent.

Phillips’s 1958 research originally mapped the connection between unemployment and wage growth, but its curved nature was largely overlooked for decades. Hauser noted that when unemployment is very low, even marginal tightening of the labor market can trigger sharp increases in wages and prices. Conversely, when unemployment is higher, its influence on inflation is more muted. This contrasts with the view held by many central banks during the 1990s and 2000s—including Australia’s—that the relationship resembled a flat line, where small unemployment changes yielded only minor inflation shifts.

That assumption proved problematic as inflation surged globally following the COVID-19 pandemic amid low unemployment and expansive monetary policy, catching many policymakers off guard. Hauser argued that the spike aligned precisely with predictions derived from a nonlinear Phillips curve. Although the RBA’s forecasting models incorporated curvature based on prior work by former economists Guy Debelle and James Vickery, they nevertheless underestimated the extent of the post-pandemic inflation surge, partly because the models were calibrated on periods with more subdued economic conditions.

New research undertaken by the RBA aims to better explain why the curve bends as it does. Hauser identified three primary factors driving this nonlinear dynamic. First, wages are sticky downward—workers generally resist pay cuts even when labor demand weakens. This resistance means that in tight labor markets, small declines in unemployment can disproportionately elevate wages. Second, the vacancy rate does not fall gradually as unemployment rises; when unemployment is low, firms must offer higher wages to fill positions due to difficulties in attracting workers. This nonlinear vacancy-unemployment relationship mirrors the Beveridge curve and sheds light on inflation’s behavior before and after COVID-19. Third, elevated inflation prompts firms to update prices more frequently, a shift that the RBA quantifies as contributing between 0.5 and 1.25 percentage points to Australia’s inflation rise since the pandemic.

These insights influenced the RBA’s decisions to increase interest rates in February, March, and May this year. The February hike responded to unexpectedly strong demand growth combined with limited supply capacity, intensifying inflationary pressures. By March, geopolitical tensions and conflict in the Middle East introduced further risks, raising concerns about potential cost shocks. By May, these risks had begun crystallizing, prompting continued policy tightening.

Hauser emphasized that the more nonlinear the labor market’s influence on inflation, the stronger the rationale for central banks to act preemptively to reduce economic capacity pressures. Importantly, the steepness of the curve means that timely policy actions could also limit the unemployment costs associated with lowering inflation. Ahead of recent meetings, the RBA’s forecasts suggested inflation could return to its target range with only a modest rise in unemployment, supporting this view.

Nevertheless, Hauser cautioned that dynamics making inflation accelerate sharply amid low unemployment can also make it difficult for the jobless rate to decline once it has risen, likening the pattern to going “up by the elevator but down by the stairs.” Such trends were evident following the early 1990s recession, which had particularly long-lasting impacts on younger workers.

Acknowledging the inherent uncertainties in real-time policy calibration, Hauser noted that a potential easing of oil prices—contingent on a resolution in the Middle East—could provide some relief for inflation. However, he stressed that no such outcome is guaranteed and reiterated the RBA’s commitment to further inflation reduction, underscoring that current levels remain unacceptably high.