Economic News & Analysis—March 20, 2014
Unemployment and inflation: The great disconnect?By Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist
Initial unemployment claims rose slightly to 320,000 for the week that ended March 15. Continuing claims rose by 41,000 to 2.889 million. Based on labor market patterns over the past 30 months, this is consistent with payrolls growing by 138,000 for March.
The data defies what is known as the Phillips Curve, which correlates low unemployment with high inflation. In 1958, the economist A.W.H. Phillips published a paper that showed a consistent relationship between inflation and unemployment in the U.K. from 1861 to 1957. When inflation was high, unemployment was low, and vice versa. This insight, which continues to be influential today, implies a trade-off for monetary policymakers between inflation and unemployment.
Over certain periods, the Phillips Curve shows some correlation between inflation
The Phillips Curve: Fact or fable?
The Phillips Curve hasn’t been a very good guide for policymakers. It didn’t work during the stagflation of the 1970s, and it doesn’t seem to work today. In all fairness, the Phillips Curve has gone through many iterations, including approaches that apply it to expected inflation, different unemployment indicators, and various time frames—but it still doesn’t seem to work that well.
The limits of the Phillips Curve: more than 65 years of data shows little correlation
between inflation and unemployment
The New York Federal Reserve published a paper saying that what really matters to inflation is short-term unemployment, not long-term unemployment. Chair Yellen was asked about that research at her first post-policymaking press conference, and she distanced herself from the research, implying that neither she nor most committee members buy this latest iteration of the Phillips Curve. In the research, the authors look at the relationship between short-term unemployment and average compensation costs. They find an inverse relationship.
Alas, just because a relationship exists doesn’t mean it is stable over time or useful for explaining the past, describing the present, or predicting the future. First, average compensation cost and actual price inflation are weakly linked. Inflation, as measured by changes in the Consumer Price Index, depends more on unit labor costs (productivity-adjusted compensation) and credit growth than simple per-hour compensation costs. Unit labor costs haven’t been rising much, and private sector credit creation—especially in the mortgage and credit card departments—hasn’t been growing more rapidly than incomes. As a result, average compensation costs and actual inflation show little connection.
A look at the relationship between short-term versus long-term unemployment and wage pressure
The Phillips Curve is a workhorse of economics, but life is much more complex than a simple inflation/unemployment trade-off model can capture. Whether you look at short-term unemployment, long-term unemployment, or both, there is little inflationary pressure building.