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Inflation and unemployment – why is inflation a problem?

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The new Achilles’ heel

In the US, there are several measures of inflation. However, when the Fed talks about inflation, it’s referring to the PCE (personal consumption expenditures) price index. According to the central bank, this indicator is the “most consistent over the longer run with the US Federal Reserve’s statutory mandate.”

The Fed focused on battling unemployment in 2012 and 2013. Now, the Fed is focused on inflation.

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Inflation and unemployment

Inflation and unemployment are related. The relationship is inverse. When unemployment is high, employers don’t need to raise wages. Individuals seeking employment won’t be in a position to negotiate. With lower wages, people will have less money to spend. This will result in weak consumer demand. Weak demand will lead to low inflation.

The opposite is true when unemployment is low. Employees have several options. They have the ability to negotiate wages.

As shown in the above graph, the relationship between inflation and unemployment isn’t always predictable. From July 2009 to the end of that year, inflation and unemployment were rising. Since September 2011, inflation and unemployment have mainly been falling. The Fed has to be mindful of inflation and unemployment before changing its monetary policy. The Fed can’t take action only if one of them looks healthy.

When will the rate increase?

“Only if inflation read better…” would be a common sigh for Fed policymakers. For them, the question of “when” has taken precedence over “why.” They haven’t been able to hike rates because there isn’t a clear trend in inflation. If they increase rates too soon, they risk pushing inflation down more and stifling growth. If they increase rates too late, inflation may run out of control due to the growing economy.

Apart from the Fed, equity (SPY)(IVV) and bond ETFs (TLT)(SHY)(IEF) have also been waiting to know when the rates will increase.

In the next part of this series, we’ll discuss what the Fed had to say about economic indicators.

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