investment viewpoints

Can inflation end without a meaningful increase in unemployment?

Can inflation end without a meaningful increase in unemployment?
Florian Ielpo, PhD - Head of Macro, Multi Asset

Florian Ielpo, PhD

Head of Macro, Multi Asset

In the latest instalment of Simply put, where we make macro calls with a multi-asset perspective, we ask whether a shared belief in the prospect of a soft-landing is enough to bring it about.  


Need to know:

  • The Federal Reserve and the European Central Bank (ECB) are actively trying to manage expectations, making the investment community believe that a soft-landing can achieved
  • This idea stems from modern economics and defies more traditional concepts such that of the Philipps curve – that high inflation dissolves only in high unemployment
  • Is it enough to collectively believe in a soft-landing for it to happen? This is the tricky question of 2023


Self-fulfilling prophecies

Modern macroeconomics is largely based on expectations – as in ’inflation expectations’. This is a strong idea that shapes of lot of the political economics we have had to benefit from or to suffer from over the past three years. Pushed to the extreme, expectation-based economics ties to the idea of self-fulfilling prophecies: if we collectively believe something will happen, then our rational decisions will naturally make that expectation come true. Today, this concept is likely to prove to be even more important than usual, as it will decide on the odds of a soft- versus a hard-landing for our regional and world economies. This edition of Simply Put digs into the concept of self-fulfilling prophecies and analyses it through the lens of the ’Fed scenario’. The scenario postulates that inflation can be ended without a meaningful increase in unemployment. This goes against the concept of Philipps curve but could still be right given how strongly we believe in it in it.


Sunspot economics

The idea of self-fulfilling prophecies is old and powerful.

It is old as it notably relates to the early work of the economist Stanley Jevons. Jevons hypothesised a relationship between sunspots activity, harvests, and economic cycles. His theory opened a debate that occupied the front stage of economics at the end of 19th century. That debate was seen by economists such as J.M. Keynes as a ’sunspot virus’ – an ill-founded way of approaching a serious business cycle theory. However, the term ‘sunspots’ traveled through time in economics to become today a synonym for a shock affecting expectations and consequently our decisions.

It is a powerful idea, and it has shaped most of the post 1980s economics, with a strong impact on business cycle analysis, growth models and asset pricing. The idea is simple: if we collectively decide to believe in something, our rational behavior will make that expectation come true. To quote Azariadis and Guesnerie (1986)1, “one may view sunspots as a convenient label for a host of psychological factors (animal spirit, fears, […]) that […] come to influence the forecasts and actions of economic decision makers.” In a nutshell, given that we suddenly collectively believe in something, our behavior will adjust rationally leading to the outcome we feared in the first place.

Inflation is the perfect example of that: if economic agents collectively start expecting a surge in inflation, then, rationally, they must rush to buy what they need before prices start rising. Doing so would collectively create a demand shock. If firms expect that demand shock to be temporary (no need to create more production facilities), they simply should hike their prices: here comes inflation. On the other hand, if we expect inflation to remain stable, we rationally start neglecting it as a decision factor – what J. Powell refers to as “rational inattention”, quoting the seminal work of Christopher Sims, 2003– and inflation remains in check with central banks’ targets. Does it work all the time? Hard to tell, but the post-Volcker era has been surfing that wave over several decades. What now?


Can I believe in the Fed scenario?

Well, well. We are currently entering into 2023 with a sunspot equilibrium in mind. That equilibrium is the one proposed by the Fed. In its forecasts dashboard published in December 2022, the Fed members expected that growth in 2023 will be of 0.5%, unemployment will rise to 4.6% (which is about the Non-Accelerating Inflation Rate of Unemployment (NAIRU), the threshold below which unemployment creates inflation), while inflation should see a decline to 3%+ from its current level. This way of conducting monetary policy is a fantastic example of how these expectations-based economic principles could be working.

Why is that? Because pre-1980s economics were based on the notion of the Philipps curve: if the Fed and the ECB want to lower inflation, then they need to hike rates until they would have created enough unemployment to see wages collapse, bringing inflation with them in their fall. Figure 1 illustrates how that principle seems to have remained true since 1985 in the US and since 2002 in the Eurozone: there exist an empirical relationship (a negative one) between unemployment in excess of NAIRU and inflation. This theory says that we need unemployment to remain above NAIRU for some time for inflation to lose its impetus. However, on both charts, the quantitative easing (QE) years seem to have weaken that relationship. Could it be that sunspots economics is taking the upper hand?


Figure 1. US (top) and European (bottom) unemployment in excess of trend vs. inflation in excess of trend

Multi-Asset-simply-put-US-EU unemployment vs inflation-01.svg

Source: LOIM, Bloomberg.


The idea of a soft-landing being a possibility is pretty much what the Fed and the ECB have to offer now. They intend to maintain rates high enough for real rates to stand close to the potential growth of their respective economies. By doing so, and actively communicating their intent,  they seem to be ready to pilot our collective expectations, in a hope to operate that soft-landing: eliminating inflation without leading the unemployment rate to exceed the NAIRU. If they succeed in their enterprise, this would be a first and ground-breaking way to doing monetary policy. Former Chair of the Federal Reserve Ben Bernanke failed there when attempting to deflate the 2007 housing bubble, but one would argue that this was because of systemic fragilities that are gone today. Well, the odds look much better today than ever, but let us not forget how a chain is only so strong as its weakest link, which we usually discover only too late. Maybe we should set our expectations somewhere inbetween a soft and hard landing and avoid to being wedded to one single possible outcome.

  Simply put, the odds of a soft-landing will rely significantly on the ability of our central banks to convince us of their scenario. Their failure at doing that should be 2023’s key risk.  



[1] Sunspots and Cycles, Costas Azariadis and Roger Guesnerie, The Review of Economic Studies, Vol. 53, No. 5 (Oct., 1986), pp. 725-737 (13 pages). Published By: Oxford University Press.

[2] Sims, C. A. (2003). Implications of rational inattention. Journal of Monetary Economics, 50(3), 665–690.

Macro/Nowcasting Corner

The most recent evolution of our proprietary nowcasting indicators for world growth, world inflation surprises and world monetary policy surprises are designed to keep track of the latest macro drivers making markets tick. 

Our nowcasting indicators currently point to:

  • The US growth nowcaster is in a recession zone, while the Eurozone and the Chinese ones are improving for the first time in a long time.
  • Inflation surprises should be negative across the board.
  • Our monetary policy nowcasting indicator remains between 45% and 55%. It has fallen this week again ahead of the Fed and ECB meeting.

World Growth Nowcaster: Long-Term (left) and Recent Evolution (right)

Multi-Asset-simply-put-Growth nowcaster-06 Feb-01.svg

World Inflation Nowcaster: Long-Term (left) and Recent Evolution (right)

Multi-Asset-simply-put-Inflation nowcaster-06 Feb-01.svg

World Monetary Policy Nowcaster: Long-Term (left) and Recent Evolution (right)

 Multi-Asset-simply-put-Monetary Policy nowcaster-06 Feb-01.svg

Reading note: LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The Nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).


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