Inflation: Are We Treating a Sore Throat With Cough Syrup?

The Fed has raised rates at a pace not seen since 1981. We question whether this is the best means to curb inflation. It has been argued that the current rate of inflation in the US is 7.9% dependent on low unemployment, and that the remaining 92.1% is caused by the war in Ukraine impacting the prices of raw materials and energy, by supply-chain disruptions and, mostly, by price gouging. Corporations are charging more because they can and posting record profits. So why not address price-gouging before destroying millions of jobs?

In this article we are going to explore the main factors that contribute to inflation, the relationship between unemployment and inflation, and analyze if the best way to decrease inflation is to leave thousands or millions of people unemployed. 

What can cause inflation

Inflation is a persistent rise in the general level of prices in an economy over time, which reduces the purchasing power of money. It happens whenever there’s “too much money chasing after too few goods.” These are the different scenarios leading to it: 

• Increase in Demand: This can occur when unemployment is low and people have more money to spend but businesses have not ramped up production sufficiently and demand outstrips supply. 

• Increase in Production Costs: When the cost of producing goods and services increases, businesses may be forced to increase their prices to maintain their profit margins. This can occur when there is an increase in the cost of raw materials, labor, or energy. The war in Ukraine has pushed up energy prices, for example.

• Increase in the Money Supply: Low rates from central banks translate into more loans to the High Street, more funding for startups, and so on. When the amount of money in circulation in the economy increases, it can lead to an increase in prices if the level of output (production of goods and services) does not rise proportionately. 

• Decrease in Productivity: When the productivity of the economy decreases, a given amount of money ends up chasing scarce goods and services, causing prices to rise.

Measures to Combat Inflation

There are several policy measures that can be used to combat inflation:

•  Monetary Policy: The Fed can use monetary policy tools to combat inflation, it may increase interest rates to reduce consumer spending and borrowing, which can help to slow down inflationary pressures. However, this can lead to a decrease in economic growth and an increase in unemployment.

• Fiscal Policy: The government can use fiscal policy to combat inflation by adjusting taxes and government spending. For example, if the government reduces spending and increases taxes, it can reduce consumer demand and slow down inflationary pressures. However, this can also lead to a decrease in economic growth and an increase in unemployment.

• Supply-side Policies: Supply-side policies to combat inflation can be implemented by investing in infrastructure and education and by removing barriers to entry and promoting innovation and competition. 

Causing Unemployment (Cough Syrup) to Curb Inflation

The relationship between unemployment rates and inflation is often referred to as the Phillips curve. This curve shows the inverse relationship between the two variables, with lower levels of unemployment associated with higher levels of inflation, and vice versa. 

However, the Phillips curve has been subject to debate and criticism over the years, particularly as the relationship between unemployment and inflation has become less clear in recent decades. Some economists argue that other factors, such as changes in productivity or supply chain issues, can also affect inflation, making it difficult to predict inflation based solely on unemployment rates. Despite these criticisms, policymakers often use unemployment rates as a key indicator of inflationary pressures in the economy. But if unemployment rates were really the problem, how come we had the same unemployment rate in 2019 as we did in March 2023 (3.5%) while inflation remained under control back then? If unemployment is not an issue, why the aggressive rate hikes?

Externalities of Increased Unemployment Rates 

Policymakers may raise interest rates, which can depress employment, which, in turn, can help curb inflation. However, rate hikes can also have negative consequences, particularly for those who rely on borrowing, such as homeowners or businesses. Higher interest rates increase the cost of borrowing, making floating rate mortgages more expensive and making it harder for individuals and businesses to access credit. 

As businesses find it harder to grow, they begin laying people off. Rising unemployment rates increase poverty and social inequality while slowing economic growth. Moreover, it can trigger a vicious cycle if it results in supply reductions. It is clear to the authors that simply increasing unemployment rates might help somewhat, but the side-effects are very painful and there are other, more direct solutions to current inflationary problems.

The Elephant in the Room: Lack of Competition

Across the world many industries have become increasingly concentrated. This fact is well illustrated by this graph published by Promarket.org. The huge bargaining power of oligopolies has allowed these corporations to keep real wages stagnant, to slow the pace of innovation, to deliver lacklustre quality and, ultimately, to push prices up.

Considering the fact that more than 50% of the increased prices in the US are directed to corporate profits, we should probably start there. We believe that competition is not just the most sustainable solution to inflation, while simultaneously promoting employment and growth. In recognition of this, Joe Biden signed an executive order to promote competition in July 2021. And while it does not magically appear overnight, the best time to plant a tree was yesterday.

When consumers have choices, providers are less willing to raise prices and risk losing customers. Moreover, by increasing the supply of goods and services and reducing the cost of production, competition can further help to keep inflation in check and promote economic growth and efficiency while fostering innovation and technological advancements. 

Markets are like sports, competition drives companies to be better, more efficient, offer better quality and lower prices. We need more entrepreneurs to build viable alternatives to traditional players. We, at Revolut, are committed to redefining the standards for banking. We are building a digital bank in Mexico to boost competition and improve the lives of millions of people. We publish vacancies periodically on https://www.revolut.com/careers/. 

(Co-written with Diego Montes Serralde)