The relationship between inflation rates and unemployment rates is inverse. However, this relationship is more complicated than it appears at first glance and has broken down on a number of occasions over the past 45 years. Since inflation and unemployment are two of the most closely monitored economic indicators, we’ll delve into their relationship and how they affect the economy.
Before entering into the tolpic, we will discuss in brief about these two key terms.
Unemployment occurs when a person who is actively searching for employment is unable to find work. Unemployment is often used as a measure of the health of the economy.
Inflation refers to the rise in the prices of most goods and services of daily or common use, such as food, clothing, housing, recreation, transport, consumer staples, etc. Inflation measures the average price change in a basket of commodities and services over time.
Labor Supply and Demand
If we use wage inflation, or the rate of change in wages, as a proxy for inflation in the economy, when unemployment is high, the number of people looking for work significantly exceeds the number of jobs available. In other words, the supply of labor is greater than the demand for it.
With so many workers available, there’s little need for employers to “bid” for the services of employees by paying them higher wages. In times of high unemployment, wages typically remain stagnant, and wage inflation (or rising wages) is non-existent.
In times of low unemployment, the demand for labor (by employers) exceeds the supply. In such a tight labor market, employers typically need to pay higher wages to attract employees, ultimately leading to rising wage inflation.
Over the years, economists have studied the relationship between unemployment and wage inflation as well as the overall inflation rate.
The Phillips Curve
A graph that shows the inverse relationship between the rate of unemployment and the rate of inflation in an economy is known as Phillips Curve.
- A.W. Phillips published his observations about the inverse correlation between wage changes and unemployment in Great Britain in 1958. This relationship was found to hold true for other industrial countries, as well.
- From 1861 until the late 1960’s, the Phillips curve predicted rates of inflation and rates of unemployment. However, from the 1970’s and 1980’s onward, rates of inflation and unemployment differed from the Phillips curve’s prediction. The relationship between the two variables became unstable.
Phillips hypothesized that when demand for labor is high and there are few unemployed workers, employers can be expected to bid wages up quite rapidly. However, when demand for labor is low, and unemployment is high, workers are reluctant to accept lower wages than the prevailing rate, and as a result, wage rates fall very slowly.
A second factor that affects wage rate changes is the rate of change in unemployment. If business is booming, employers will bid more vigorously for workers, which means that demand for labor is increasing at a fast pace (i.e., percentage unemployment is decreasing rapidly), than they would if the demand for labor were either not increasing (e.g., percentage unemployment is unchanging) or only increasing at a slow pace.
Since wages and salaries are a major input cost for companies, rising wages should lead to higher prices for products and services in an economy, ultimately pushing the overall inflation rate higher. As a result, Phillips graphed the relationship between general price inflation and unemployment, rather than wage inflation. The graph is known today as the Phillips Curve.
Phillips Curve Implications
Low inflation and full employment are the cornerstones of monetary policy for the modern central bank. For instance, the U.S. Federal Reserve’s monetary policy objectives are maximum employment, stable prices, and moderate long-term interest rates.
The tradeoff between inflation and unemployment led economists to use the Phillips Curve to fine-tune monetary or fiscal policy. Since a Phillips Curve for a specific economy would show an explicit level of inflation for a specific rate of unemployment and vice versa, it should be possible to aim for a balance between desired levels of inflation and unemployment.
The Consumer Price Index or CPI is the rate of inflation or rising prices in the U.S. economy.
Figure 1 shows the CPI and unemployment rates in the 1960s.
If unemployment was 6% – and through monetary and fiscal stimulus, the rate was lowered to 5% – the impact on inflation would be negligible. In other words, with a 1% fall in unemployment, prices would not rise by much.
If instead, unemployment fell to 4% from 6%, we can see on the left axis that the corresponding inflation rate would rise to 3% from 1%.
Figure 1: U.S. inflation (CPI) and unemployment rates in the 1960s
CPI vs Unemployment
CPI is a general consumer price index compared to the base year. An increase in CPI means inflation.
In the graphs below, we can see the inverse correlation between inflation, as measured by CPI, and unemployment reasserts itself, only to break down at times.
U.S. Consumer Price Index (CPI) or Inflation Rate: 1998 to 2017
- In 2001, the mild recession, as a result of 9-11, pushed unemployment higher to roughly 6% while inflation fell below 2.5%
- In the mid-2000s, as unemployment fell, inflation climbed to almost 5% before coming back down in 2006 when unemployment bottomed
- During the Great Recession, CPI fell dramatically as unemployment soared to almost 10%
- From 2012 to 2015, we can see that the inverse correlation broke down where inflation and unemployment moved in tandem
- Over the past two years, unemployment has fallen, while inflation has begun to rise, albeit not by much
- Since 2010, U.S. inflation has remained stubbornly low even (currently 2.5%) as the unemployment rate has trended steadily lower from 10% in October 2009 to roughly 4% in 2018. In other words, the inverse correlation between the two indicators isn’t as strong as it was in prior years