Pandemic Pandemonium: Inflation and the Philips-curve

 t is clear that the pandemic has created unprecedented conditions which experts have tried to quickly find solutions and corrections to. In the economic sphere, the shock in demand and mandated closure/limiting of businesses lead to huge unemployment rates. As a solution, the government adopted giant expansionary fiscal policy, resulting in huge debates about inflation amongst economists and one of the biggest policies was President Biden’s $1.9 trillion Covid-19 relief bill (Stewart). Here we go over the phillips-curve's (PC’s) relationship between inflation and unemployment, it’s historical inaccuracies and potential improvements, the debate about inflation, and where all of this leaves us at the moment according to economic theory.

In short, mandated limiting of in-person business shocked demand and led to a spike in unemployment which only exacerbated plummeting demand, and to remedy this the government enacted extreme expansionary policy measures in order to slow down this shock in demand and prevent further spikes in unemployment (see graph under blog). According to the PC, unemployment is inversely related to inflation; however, this has not held up well historically. Two salient examples of this are the stagflation which occurred in the 70s and recent low unemployment. In the first case unemployment and inflation were both high, and in the second case unemployment and inflation were both low (compare graphs under blog). This directly violates the PC in unemployment and inflation were directly related rather than inversely related. One question arises: How is the intuition that low-unemployment leads to higher inflation through higher demand and thus an increase in prices, and so to lower unemployment leads to lower demand causing prices to decrease, wrong? Bearing this in mind, we now turn to the inflation debate surrounding recent policy decisions.

Now, unemployment claims have dropped to 576,000, the lowest since the beginning of the pandemic began, a total of 16.9 million people are continuing to collect unemployment benefits, down from 18.2 million in the previous week as of April 15th 2021, and many indicators point towards business slowly picking up (KTLA, 2021). In light of this, and the rapid introduction of liquidity into the economy, some are alarmed that inflation may soon run rampant. Again, this liquidity was introduced through recent government spending, like the stimulus checks and is seen in the M1 money supply graph.

“Some economists and experts have warned that [the expansionary fiscal policy] is too much, and that once the economy recovers — perhaps rather quickly, thanks to the vaccine — the country won’t have enough capacity to meet demand and the economy will overheat, resulting in an increase in prices (Stuart, Emily 2021).”

However, there are many other economists, including Paul Krugman, that believe that if inflation were to come the FED has enough “easy” tools to help combat it (Stewart, 2021). This line of argument rests on interest rates, set by the FED, being near zero. Should demand spike after the recovery, not only will increased interest rates curb demand by disincentivizing debtors but also give the FED room to cut interest rates in the event of another recession. Concerning the PC relation, that is now that unemployment rate is going down the PC would predict inflation to go up,

“‘the consensus is still the Phillips curve isn’t dead, but the world has changed, so maybe the way it works has changed,’ said Raphael Schoenle, deputy director of the Center for Inflation Research at the Federal Reserve Bank of Cleveland. In a 2018 interview, [Jay] Powell said he believes the curve may not be dead, but it is at least ‘resting,’ (Stuary, Emily 2021).

In other words, the PC is not a great model for forecasting inflation as it stands, but with a few modifications it could be a useful tool. The journal we looked into took several variations of the PC and tried to determine which variation held best in its forecasting power, using historical data. The journal’s results are that the PC is more accurate with Time-Varying Coefficients and when it corrects for the business cycle and other activity measures, rather than just unemployment (Abdelsalam, Mamdouh, 2017). In other words, improvements upon the PC negate simple relationships between unemployment and inflation—answering the question at the end of the second paragraph with inflation having other factors outside of employment. Leaving us with no choice but to wait and see how the current economic environment will develop.

M1 Money Stock:

(Board of Governors of the Federal Reserve System (US), M1 Money Stock [M1SL], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/M1SL, April 21, 2021.)

Unemployment 

(U.S. Bureau of Labor Statistics, Unemployment Rate [UNRATE], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/UNRATE, April 21, 2021.)

Inflation

(Federal Reserve Bank of Atlanta, Sticky Price Consumer Price Index less Food and Energy [CORESTICKM159SFRBATL], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/CORESTICKM159SFRBATL, April 21, 2021.)

Citations:

Abdelsalam, Mamdouh Abdelmoula M, “Improving Phillips Curve's Inflation Forecasts under Misspecification,” Romanian Journal of Economic Forecasting, v. 20, Iss. 3, (2017).

 

Board of Governors of the Federal Reserve System (US), M1 Money Stock [M1SL], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/M1SL, April 21, 2021.

Press, Associated. “Unemployment Claims Plunge to 576,000, Lowest in U.S. since Pandemic Began.” KTLA, KTLA, 15 Apr. 2021, ktla.com/news/nationworld/unemployment-claims-plunge-to-576000-lowest-in-u-s-since-pandemic-began/.

Federal Reserve Bank of Atlanta, Sticky Price Consumer Price Index less Food and Energy [CORESTICKM159SFRBATL], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/CORESTICKM159SFRBATL, April 21, 2021.

Stewart, Emily. “How Much to Worry - and Not Worry - about Inflation.” Vox, Vox, 24 Mar. 2021, www.vox.com/policy-and-politics/22346376/inflation-rate-explained-federal-reserve. 

U.S. Bureau of Labor Statistics, Unemployment Rate [UNRATE], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/UNRATE, April 21, 2021.