A couple of days ago, I found myself explaining inflation, interest rates, and unemployment rate to a friend. My understanding is based largely on a book, 21st Century Monetary Policy by Ben S. Bernanke that I had just finished reading. One question that came up was whether inflation will continue to remain high for a decade or more as it did in the 1970s. My response to it was that it is unlikely since the Federal Reserve has a much better grasp on monetary policy today than it did then. This is worth a deeper dive; before we do so, I will address a few basics
What is inflation, and why is it a problem?
Inflation is the change over time of the price and goods and services in the economy. A common indicator of inflation is the Consumer Price Index (CPI) that measures the price of a basket of 80,000 goods and services every month. The inflation rate is the percentage change in the price of this basket relative to a year ago. High inflation reduces the value of one’s savings and makes it harder for one to plan for the future.
Why does the Federal Reserve raise interest rates in response to inflation?
The Federal Reserve (i.e. the Fed) has the dual mandate of keeping unemployment rates and inflation under check. It typically raises the Fed Fund Rate (FFR) to incentivize more savings through higher rates on savings, which in turn reduces the money in circulation in the economy, and puts the brakes on rising prices. It has to do so carefully, since raising rates too quickly can reduce money supply drastically and hurt economic growth or even drive the economy into a recession.
Why does unemployment rate matter?
Prior to the 60s, inflation and unemployment were seen to have an inverse relationship, referred to as the Phillips curve. A decline in unemployment rate results in a demand for labor, and consequently increase in wages. This causes firms to raise prices due to the increased costs, resulting in inflation. Consequently, periods of low inflation were associated with high employment.
The 70s were a time of both high inflation and high unemployment rate, and in the decades since the 80s, both inflation and unemployment rate has remained low. This has led some to question whether the Phillips curve is still valid. The high inflation and unemployment rate in the 70s is attributed to supply side shocks i.e. high gas prices that caused overall prices to increase and is not accounted for in the Phillips curve. The low inflation and unemployment rate since the 80s has been attributed to the Fed’s monetary policy.
What is causing high inflation right now? Is it here to stay?
The current high inflation has been attributed to post-pandemic supply shortages and the oil price hikes as a result of the Russian invasion of Ukraine. One could argue that the scenario is similar to the high oil prices, and more broadly the supply shocks of the 70s that led to sustained high inflation and unemployment, and consequently the view that inflation is here to stay. However, the long period of high inflation was sustained by an unwillingness by the Fed at that time to use monetary policy to combat inflation believing that it would push the economy into recession, and instead relying on wage controls as being more effective. In the 50 years since then, Fed’s experience in handling inflation and unemployment has undergone significant improvements as evidenced by its ability to handle both through the subsequent decades. Given the Fed’s track record since the 70s, it is expected that inflation is unlikely to be a decade long presence as before. In its September 2022 meeting, the Fed forecast inflation (PCE) to be in the range of 2.6-3.5% in 2023 and 2.1-2.6% in 2024, relative to 5.3-5.7% in 2022. This will likely be accompanied by a small increase in unemployment rate from a current value of 3.8% to up to 4.6%. All else being equal, which is to say that as long as there is no unanticipated global crises, we expect inflation to subside starting next year.