Understanding the Inevitable Trade-off: The Challenge of Curbing Inflation Without Incurring Costs
In the world of economics, there has always been a delicate balance between controlling inflation and avoiding the negative consequences of a recession. This trade-off, known as the Phillips curve, has been the cornerstone of traditional economic theory for decades. However, recent claims made by Janet Yellen, former Chair of the Federal Reserve, suggest that high inflation can be curbed without resulting in a recession. This bold claim has sparked a heated debate among economists and policymakers.
Yellen argues that generating meaningful inflation from the labor market is crucial for controlling inflation. Without a rise in wages, inflation pressure would not be real. While wages have indeed increased in recent years, Yellen’s claim challenges her own previous stance on the matter. It is important to note that this trade-off is not easily observed from short periods of data or without appropriate measurement tools.
To better understand this complex relationship between inflation and unemployment, economists have turned to the Phillips curve. By plotting the core inflation rate against the U6 unemployment rate, a clearer picture emerges. The data reveals a hyperbolic locus, indicating a power law relationship between the two variables. However, it is interesting to note that this fitted trend seems to ignore recent periods of high inflation, suggesting that outliers may have a significant impact on the overall relationship.
Taking these outliers into account, the slope of the relationship becomes more negative. In fact, a 50° rotation of the fitted ellipse reveals a slope of about -1.2, which is larger in magnitude than the estimated -0.8 from the previous equation. This suggests that driving down the inflation rate by 1 percent would require a similar percentage increase in the unemployment rate.
With this analysis in mind, it becomes clear that the trade-off between inflation and unemployment has not vanished. The notion of a Goldilocks economic outlook, where inflation is well-contained without negative consequences, is dangerous and likely unrealistic. It is probable that either inflation will soon rise meaningfully or a recession, with a corresponding increase in unemployment, will be necessary to curb inflation.
As economists and policymakers continue to grapple with this challenge, it is essential to consider the long-established principles of economic theory. While it is tempting to pursue a scenario where inflation is kept in check without incurring costs, history has shown that such a trade-off cannot be easily overcome. A comprehensive understanding of the Phillips curve and its implications is crucial for making informed decisions and ensuring the stability of our economy.
