Two weeks ago, in “Cheshire Cat’s Smile: ‘What Is The Fed Worried About?’”, I regaled readers with some of my patented island anecdotes on the way to warning folks about the perils associated with trying to discuss the Phillips curve at local bars.

Somehow, I managed to segue from that into a some excerpts from what, at the time, was the latest from Deutsche Bank’s brilliant Aleksandar Kocic who, three Fridays ago, delivered a Phillips curve history lesson complete with the following color and accompanying visual:

The Phillips curve has asserted its importance in an unorthodox way and, as such, attained a special status; it inhabits a space different from other macroeconomic frameworks and metrics. In each cycle, it falls apart, but after every annihilation, it re-composes itself and continues to play an important role. It appears “indestructible”, but not in a conventional way, more like a survivor of one’s own death. Phillips curve functions like an organ without a body, an equivalent of Cheshire cat’s smile (in Alice in Wonderland) that persists alone, even when the cat’s body is no longer present. This time is no different in our view. The figure shows the Philips curve through several cycles starting in mid-1980s. Each cycle has a different color which implicitly marks their beginning and end. The first thing one observes is that this is more of a “spaghetti” then a curve. The main reason is that it captures different cycles – a testimony to its falling apart and recomposing itself after each.

The implication there, clearly, is that the Fed is likely concerned that should they deviate from their (relatively) hawkish course, they could get caught flat-footed by a suddenly not-so-flat Phillips curve.

If they were then forced to hike aggressively, they risk a scenario where they hike the economy into recession but inflation fails to respond quickly to the change in monetary policy. In other words: they risk stagflation.

Naturally, the course of U.S. fiscal policy and the threat of a global trade war makes those worries all the more vexing.

On the fiscal policy front, piling stimulus atop a late-cycle economy raises the risk that inflation will suddenly materialize as we reach a tipping point beyond which the left-for-dead Phillips curve jerks back to life like the villain at the end of an 80’s slasher flick.

As far as how the trade war factors into all of this, I discussed it at length utilizing some quotes from a recent Barclays note in a followup to the post mentioned above called “The Real Estate Developer, The Chinese Strongman And Cheshire Cat’s Smile“. Here are some excerpts from that:

Consider that in the context of the tariffs and, more broadly, in the context of the effort to roll back globalization.

“Economic theory suggests that globalization is likely to have had a negative effect on inflation both in terms of its level as well as its volatility,” Barclays writes, in a note dated June 7. They cite four factors to support that contention, one of which is the idea that “trade can increase price and wage flexibility domestically, leading to a flattening in the Phillips curve.” Here’s some technical work:

Figure 8 shows different specifications of a reduced form Phillips curve involving domestic and foreign variables, pooled across G10 countries over two sample periods, 1985-2003 and 2004- 2016. The inflation-domestic output gap sensitivity has declined substantially, whereas the sensitivity to external prices (import prices) and the global output gap has increased, coinciding with the period of rising globalization. Figure 9 confirms that inflation has been negatively related to openness for a number of G10 and EM countries, but this sensitivity is particularly low among G10 countries (Figure 10). We find that increased openness has coincided to the decline in inflation globally, even after controlling for output gaps and central bank independence in a pooled regression.