U.S. Inflation Rates and Unemployment:
a Forecast for 1999 and 2000
 
CYNTHIA E. SMATHERS
College of Business
Western Carolina University
 
Abstract

U.S. inflation is forecast to increase slightly in 1999 and decrease toward current levels in the year 2000. The New Classical School interpretation of the Phillips Curve is the approach used in the forecast. U.S. monthly inflation and unemployment rates from January 1993 through December 1998 were used to forecast inflation. The forecast implies stable inflation and unemployment throughout 1999 and 2000. Average annual inflation of 2.22% is forecast for 1999, with 1.94% for 2000. (JEL: E130)
 

Part 1. Introduction
 
This paper forecasts U.S. inflation rates for the years 1999 and 2000. The explanatory variable is the seasonally adjusted unemployment rate. The approach is based on the New Classical School interpretation of the Phillips Curve. The Phillips Curve was used because it asserts a short-run theoretical relationship between inflation and unemployment rates. It is important to have a forecast that will allow us to see the inflation rates for the next two years. Future inflation can be used to predict future employment rates, given static expectations. With expectations held constant, the short-run Phillips Curve intersects the natural rate of unemployment curve (approximately 6%) at the expected inflation rate (Thomas 1997, p. 442).

If the government and the Fed correctly identify the expected inflation rate, they can deliver a higher-than-expected rate of inflation in the short-run. This in turn allows more workers to be hired to produce higher-priced goods. If the government and the Fed attempt to lower the unemployment level through inflationary policies, it is very important for the inflation forecast to be as accurate as possible.

The rest of this paper is organized as follows: Part 2. presents the data used to forecast inflation rates; Part 3. presents the theoretical basis for the approach adopted in forecasting inflation rates; Part 4. presents forecasts of inflation rates for 1999 and 2000; Part 5. evaluates the importance of the forecast for the economy; and Part 6. discusses conclusions for economic policy.
 

Part 2. Data

The first variable is inflation. The rates are computed from the Consumer Price Index: Total; All Urban Consumers. This data was taken from the Federal Reserve Bank of St. Louis Federal Reserve Economic Data (FRED). The FRED descriptor is CPIAUCSL. The inflation rate was computed as the annualized percent change in the CPI. The rates used for the sample period were seasonally adjusted annual rates for each month from 1993 to 1998. The second variable was unemployment. The FRED descriptor for the unemployment rate is UNRATE. The rates taken for the sample period were from every month from years 1993 to 1998. The forecast horizon is two years into the future. This data was used because it is readily available over the Internet and practically anyone who wants this information can easily find it there. Inflation and unemployment are essential parts of the Phillips Curve so they had to be used to complete the forecast.

 
Part 3. The New Classical Phillips Curve as a Forecasting Instrument

The Phillips Curve and variables were used because of the relationship that exists between them. Data was found on unemployment and inflation that ultimately led the project to its conclusion. The data found stated ".. we can only reduce inflation, for any given rate of increase productivity, at the cost of higher unemployment". (Mueller 1966, p. 439.) This puts into words the short-run Phillips Curve relationship between unemployment and inflation. Unemployment is a function of inflation in the Phillips Curve:

u = f(i),

Where i = inflation and u = unemployment. The regression model used is the basic univariate model. Solving for inflation, the forecast target, the equation is written as:

it = a+ but

The constants a and b are computed in the regression and are given as the intercept coefficient (a) and X variable coefficient (b). Lagging the right-hand-side of the Phillips Curve by twenty-four months yields the following forecasting equation:

it = a+ but-24

This equation is estimated in Part 4 and is used to calculate the inflation forecast.

 
Part 4. A Forecast of U.S. Inflation Rates, 1999-2000

Unemployment was lagged twenty-four months to forecast inflation. The R-square is 0.46997 and the adjusted R-square is 0.4608, indicating approximately 46% of the variation in inflation is explained by variation in unemployment from two years earlier. The regression estimate is (with t-statistics in parentheses):

it = -0.855(-1.85) + 0.6227(7.17)ut-24

This equation will give the expected inflation rates when unemployment rates from the past two years are put in. The following equation is for the forecast inflation rate for December 1999 and the X variable is unemployment from the month of December in 1997:

2.071144 = -0.855 + 0.6227 (4.7)

This equation is shown as an example of how the inflation forecast was computed for each month in 1999 and 2000. Forecast inflation rates are given in Table 1.
 
Table 1
Forecast of Inflation Rates, 1999-2000
Months in 1999
Forecast Inflation 
  
Months in 2000
Forecast Inflation 
January
2.44%
  
January
2.01%
February
2.44%
  
February
2.01%
March
2.32%
  
March
2.07%
April
2.26%
  
April
1.82%
May
2.195%
  
May
1.88%
June
2.26%
  
June
1.95%
July
2.195%
  
July
1.95%
August
2.195%
  
August
1.95%
September
2.195%
  
September
1.95%
October
2.07%
  
October
1.95%
November
2.01%
  
November
1.88%
December
2.07%
  
December
1.82%
 
This forecast predicts higher than current inflation over the next year, but predicts declining inflation throughout the forecast period. The inflation rates forecast for 1999 are almost 1% higher than current inflation. In two years the rates are expected to decline throughout the year, almost back to current levels. Using the relationship between inflation and unemployment, this forecast suggests the increase in inflation will further lower unemployment over 1999, with a slight increase in unemployment by December 2000.
 

Part 5. Forecast Implications: Steady as She Goes

The results of the forecast are quite believable. It would not be surprising for inflation and unemployment to remain very low for the next two years. The unemployment rate now is at 4.3% for 1998. Since the unemployment rate and inflation rate are inversely related in the short run, the forecast implies unemployment rates will be about the same, with a possibility of unemployment being even lower throughout 1999. Then unemployment will rise back to almost the exact percent it is now by December 2000, as inflation rises back to current levels. Employer difficulty in filling job vacancies should moderate at that time. Low forecast inflation suggests anyone thinking of buying any large purchase such as a home or car should do so within the next couple of years while inflation rates are still low.
 

Part 6. Policy Conclusions
 
In 1999, the inflation rate will rise, at most, to 0.8 % above its current level and, at most, 0.4% above its current level in 2000. If this forecast comes true, industries like automobile manufacturing, housing construction, and real estate sales, will continue to do well. Service workers should expect stable incomes because the low unemployment levels should promote consumer spending. In the financial service industry there could be more jobs for professional money managers because of increased wealth accumulation. The government should still be concerned about the unemployment level but realize it is about as good as its going to get. The Federal Reserve should continue its tight-money policy.
 
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