Blog Post #8: Predicting Increase in Unemployment Rate: Volker Style

Before I would write about Fed’s decision for Saturday’s post (which Fed must have made their decision to rather increase the interest rate or not as I am writing this), I want to write about something that needs our attention. Disinflation, the idea that first struck me when I was taking ECON 402, may be on our horizon. I am going to use this and make an educated guess as to what will happen to our unemployment rate.

The most famous case of disinflation happened during Reagan’s administration and Volker was at the helm of Fed (hence, where the term “Volker Disinflation” comes from). To explain this phenomenon, we can start with Phillips Curve. The basic idea is, with the Phillips Curve (with high variability), there is a negative relationship between inflation (percentage price change, positive or negative) and unemployment rate. It is mainly caused by the change of expectation of market by the economic agents (in this case, people like me purchasing goods and working to earn money) based on “economic condition,” in this case unemployment rate. Of course there is a Business Cycle theory that justifies inflation with business cycle, but I am just going to respectfully set it aside for the sake of argument. To sum up, what this means is that (increase) in unemployment rate is necessary to bring down the inflation (Milton Freedman defined inflation as a monetary phenomenon). The key point is the INCREASING rate of unemployment to permanently (and surgically) change the expectation. Some of the concept here is (myself) learned from Krugman’s blog plost in NYTimes.

To be clear, unemployment rate right now is (slowly) decreasing, and current inflation rate is next to zero. Now, Lets look at plot generated from FRED with unemployment rate and inflation rate percentage changes, which this plot is part of the article of Krugman’s.

Volker Disinflation

The disinflation that I am looking at is shaded region, where there is increase in unemployment rate (notice y-axis and what they represents, which is a percentage change [semi-elasticity, in econometrics term]). I want to pay attention to the period in between the shaded region, where unemployment rate is decreasing in slower rate. And then, they merge. Unemployment rate spikes up and inflation rate decreases.

Now, I want to turn our attention to FRED plot that I generated.

unemp and inflation growth

We can observe that the percentage change in unemployment rate and inflation rate is merging, like it did before disinflation around 1982. So, we may expect the disinflation this year or next.

The Wall Street Journal’s Pedro Nicolaci Da Costa has similar vision. According to his article, inflation has not even close to 2% target rate. Now, comparing it to Inflation Expectations measured by University of Michigan Survey’s of Consumers, the expected inflation rate of beginning of 2015 is decreasing below 2.5%. What that means is, if Fed manages to get the inflation rate back up to 2~2.5%, and consumer’s expectation is going below 2.5%, that is the perfect definition of disinflation. Some experts according to Nicolacia Da Costa is expecting disinflation for first quarter or so this year with this evidence. However, the question that I am trying to answer is what will happen to unemployment rate. That goes back to the introduction with Phillips Curve. The prediction: it will go (spike) up like it did during Volker’s days.

If my analysis is correct, then (increase) growth rate of unemployment rate will spike up very soon. The question is, how much our expectation would change after the disinflation, and how much it (percentage change of unemployment rate) will change?

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