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Economy in Brief

The World that Time Forgot...Is It Back?
by Robert Brusca  January 10, 2022

On the face of it the Phillips curve that had just a year ago seemed to be so irrelevant, so flat, so '1970s' is now back in full force (farce?) and has become so much of a problem.

In EMU inflation has risen. In the US inflation has risen. And in EMU the unemployment rate continues to fall and to do so broadly. While in the US the unemployment rate continues to fall and to do so broadly and sharply.

Are we back in the world that time forgot but that the Phillips Curve remembers?

It is going to take time to tell but the risk clearly is that we are back in a world that does share some of those problems with the past. The EMU unemployment rate ranks in the lower one-half of one percent of its queue of all unemployment rates back to 1993. However, the inflation rate is EMU ranks as being in the top two percentile since November 2020. Over the last year or so a Phillips Curve does fit the EMU data. But there is a sense in which the cross-section data do not conform to a Phillips Curve notion. By that I mean that the ranking of EMU members based on where their relative inflation rates are today is not explained by the ranking of countries based on the relative level of their unemployment rates. In EMU inflation is a macroeconomic phenomenon and does not seem to be oozing up from country sources.

The shock of Covid ratcheted up inflation in and across EMU in 2021. Germany is suffering its highest 12-month inflation in the whole period since late 1997. Among the 12 earliest EMU members (Austria, Belgium, Finland, France, Germany, Greece, Ireland, Luxembourg, The Netherlands, Portugal, and Spain) ten have inflation that ranks among its highest values (top ten percentile) by country since 1997. The lowest inflation rate ranking is for Portugal in its 68 percentile (at a 2.6% pace) - there is no serious exception to high inflation in EMU. As for unemployment, all unemployment metrics rank below their own medians except for three (Austria 59.1%, Luxembourg 63.1%, and Greece 52.8%). The extremely low unemployment ranking for all of EMU (0.5 percentile ranking) is largely on the back of Germany's 3.2 percentile ranking, however, France, Finland, and The Netherlands also have single digit unemployment rate rankings on the period. It is the combination of all this low unemployment news at once that has driven the EMU rate standing so low

The real question about the Phillips Curve has to do more with market and worker reactions in the future. The US generates a stronger-looking Phillips Curve signal than Europe because its unemployment displacement was so much greater as Covid struck followed by a sharp unemployment rate decline as Covid lockdowns receded. The unemployment ranking for the US is in its 14.5 percentile. And US inflation is quite hot to boot.

The ECB is motivated to get control of its inflation rate as it is now well above its simple 2% target but since it, like the US has adopted an averaging process, no one really knows what inflation looks relative to the average used by the central bank to assess it. And for now the ECB's motivation to tame inflation seems to be limited to waiting and forecasting.

But with the EMU wide unemployment rate so low and most countries with low rates of unemployment as well the ECB overall attention is turning to the ECBs inflation overshoot that has become quite severe although not as bad as the overshoot in the US. There are clearly different points of view on policy within the ECB.

The overall EMU unemployment rate continues to fall. Unemployment has dropped by 0.2 percentage points over 3-months, by 0.8 percentage points over 6-months and by 0.9 percentage points over 12-months. Progress in reducing unemployment is ongoing. And at the same time inflation has been rising well above the ECB's target - something will have to give soon. A good deal of ECB attention right now is aimed at oil prices: spot oil as well as the impact of moving to green energy sources and a current natural gas shortage that is exacerbating energy prices in Europe. For now, the ECB is looking at an inflation overshoot in 2022 that will calm back down and behave relative to its target the next year- at least that is the current outlook.

The question looking ahead is how much inflation expectations and workers' demands will be affected by the inflation Europe has seen as well as what it has yet to see in 2022. If inflation psychology gets embedded in markets the Phillips Curve will probably revive and the ECB will be forced to act. If not, then central bankers can deal with the virus and its impact on prices and inflation as a one-off event.

Right now, the ECB view on inflation is as one-off or transitory phenomenon. That view is losing favor everywhere else- but especially in the US. Supply chains have been affected globally. There are goods in short supply and it looks like many of the market forces that are elevating prices in 2021 are going to have some staying power in 2022 (ECB looks for 3.2% inflation in 2022). It is too early to decide that inflation will, like a ground hog, look up, see its own shadow, then simply decide to go away. But for 2023 that is about the ECB forecast as it sees inflation dropping back to 1.7% by then. Christine Lagarde has said quite pointedly that, "It is very unlikely that we will raise interest rates in the year 2022."

Ending 2021 with 5% inflation compared to a target at 2% puts the central bank well behind the eight ball, even with an averaging process and undershoots in previous years. The problem with letting overshoots occur and justifying them with previous undershoots is that at some point this year's results become a 'previous year' and its inflation numbers become a part of the process that makes up the next average looked at by the centrals banks in the future. If inflation stays too high for too long it will be factor causing policy to become tighter later on. However, so far, the ECB is being stubborn and does not see a rise in borrowing costs on the horizon for the year ahead. But the Federal Reserve took this same posture and then suddenly shifted and now is tapering its bond purchases- tapering faster- looking for three rate hikes in 2022, and looking to use balance sheet policy in addition to rate hikes to achieve some measure of monetary control. For now, the Fed and ECB are polar opposites; either that or the Fed is a preview of coming attractions for the ECB later this year when wishing, planning, hoping and scheming fails to bring inflation down fast enough and action is required.

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