How Inflation and Unemployment are Related

The relationship between inflation and unemployment has traditionally been an inverse correlation. 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 (un)employment are two of the most closely monitored economic indicators, we'll delve into their relationship and how they affect the economy.

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.

A.W. Phillips was one of the first economists to present compelling evidence of the inverse relationship between unemployment and wage inflation. Phillips studied the relationship between unemployment and the rate of change of wages in the United Kingdom over a period of almost a full century (1861-1957), and he discovered that the latter could be explained by (a) the level of unemployment and (b) the rate of change of unemployment.

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 of 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.

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

Source: U.S. Bureau of Labor Statistics

The 1960s provided compelling proof of the validity of the Phillips Curve, such that a lower unemployment rate could be maintained indefinitely as long as a higher inflation rate could be tolerated. However, in the late 1960s, a group of economists who were staunch monetarists, led by Milton Friedman and Edmund Phelps, argued that the Phillips Curve does not apply over the long term. They contended that over the long run, the economy tends to revert to the natural rate of unemployment as it adjusts to any rate of inflation.

The natural rate is the long-term unemployment rate that is observed once the effect of short-term cyclical factors has dissipated and wages have adjusted to a level where supply and demand in the labor market are balanced. If workers expect prices to rise, they will demand higher wages so that their real (inflation-adjusted) wages are constant.

In a scenario wherein monetary or fiscal policies are adopted to lower unemployment below the natural rate, the resultant increase in demand will encourage firms and producers to raise prices even faster.

As inflation accelerates, workers may supply labor in the short term because of higher wages – leading to a decline in the unemployment rate. However, over the long-term, when workers are fully aware of the loss of their purchasing power in an inflationary environment, their willingness to supply labor diminishes and the unemployment rate rises to the natural rate. However, wage inflation and general price inflation continue to rise.

Therefore, over the long-term, higher inflation would not benefit the economy through a lower rate of unemployment. By the same token, a lower rate of inflation should not inflict a cost on the economy through a higher rate of unemployment. Since inflation has no impact on the unemployment rate in the long term, the long-run Phillips curve morphs into a vertical line at the natural rate of unemployment.

Friedman's and Phelps' findings gave rise to the distinction between the short-run and long-run Phillips curves. The short-run Phillips curve includes expected inflation as a determinant of the current rate of inflation and hence is known by the formidable moniker "expectations-augmented Phillips Curve."

(*Note: The natural rate of unemployment is not a static number but changes over time due to the influence of a number of factors. These include the impact of technology, changes in minimum wages, and the degree of unionization. In the U.S., the natural rate of unemployment was at 5.3% in 1949; it rose steadily until it peaked at 6.3% in 1978-79, and then declined afterward. It is expected to be at 4.8% for a decade starting from 2016.)

The monetarists' viewpoint did not gain much traction initially as it was made when the popularity of the Phillips Curve was at its peak. However, unlike the data from the 1960s, which definitively supported the Phillips Curve premise, the 1970s provided significant confirmation of Friedman's and Phelps' theory. In fact, the data at many points over the next three decades do not provide clear evidence of the inverse relationship between unemployment and inflation.

The 1970s were a period of both high inflation and high unemployment in the U.S. due to two massive oil supply shocks. The first oil shock was from the 1973 embargo by Middle East energy producers that caused crude oil prices to quadruple in about a year. The second oil shock occurred when the Shah of Iran was overthrown in a revolution and the loss of output from Iran caused crude oil prices to double between 1979 and 1980. This development led to both high unemployment and high inflation. 

The boom years of the 1990s were a time of low inflation and low unemployment. Economists attribute a number of reasons to this positive confluence of circumstances. These include:

• The global competition that kept a lid on price increases by U.S. producers
• Reduced expectations of future inflation as tight monetary policies had led to declining inflation for more than a decade
• Productivity improvements due to large-scale adoption of technology
• Demographic changes in the labor force, with more aging baby boomers and fewer teens

In the graphs below, we can see the inverse correlation between inflation, as measured by CPI, and unemployment reassert itself, only to break down at times. 

• 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

CPI chart from Bureau of Labor Statistics.

Unemployment Data from Bureau of Labor Statistics.

An unusual feature of today's economic environment has been the paltry wage gains despite the declining unemployment rate since the Great Recession.

• In the graph below, the annual percentage change in wages (red dotted line) for the private sector has barely nudged higher since 2008 
• Over most of the past decade, inflation has also been under control

Wage graph from the Bureau of Labor Statistics.

The inverse correlation between inflation and unemployment depicted in the Phillips Curve works well in the short run, especially when inflation is fairly constant as it was in the 1960s. It does not hold up over the long-term since the economy reverts to the natural rate of unemployment as it adjusts to any rate of inflation.

Because it's also more complicated than it appears at first glance, the relationship between inflation and unemployment has broken down in periods like the stagflationary 1970s and the booming 1990s.

In recent years, the economy has experienced low unemployment, low inflation, and negligible wage gains. However, the Federal Reserve is currently engaged in tightening monetary policy or hiking interest rates to combat the potential of inflation. We have yet to see how these policy moves will have an impact on the economy, wages, and prices.