Economic theory suggests that inflation and employment should be positively correlated with one another, and for the most part this has been true in practice. The relationship between the two variables isn’t quite as strong as theory would suggest, however, and this has big implications in the real world.
Imagine everyone who wanted a job had a job. That is, imagine there was no unemployment. There’ll always be some people without a job, but often many of those people are choosing not to have a job, so they don’t count as being unemployed. Then there’s children and the elderly, who also don’t count as unemployed despite not working.
So, everyone who wants a job has a job – what would that mean for the economy? On the face of it, that would be great. Everyone would be earning and spending, and that would create a positive feedback loop through the economy that would lead to further increases in the welfare of the population. As the economy grows, however, employers will generally need to hire more people. Since there aren’t any willing workers without a job, employers may have to start poaching workers from other employers. This excess of demand over supply of labour (workers) causes the price of labour to rise. Or, put another way, workers can demand higher wages!
In order to cover their higher wage bills, employers will raise the prices of the things they sell and the services they provide. That’s possible because people are generally earning more, so they can afford to pay more for the things they buy. But this wage-price-wage-price spiral can quickly get out of control. The rate of increase in the price level in an economy, which is often closely linked to the increase in the wage level, is inflation. So, you can see the positive relationship between inflation and employment. That relationship is called the Phillips Curve.
In order to prevent an inflationary spiral, central banks tend to raise interest rates when the economy begins to ‘overheat’, which in the past has often been evident in the rate of unemployment falling to extremely low levels. By raising interest rates, the central bank intentionally tips the economy into a slowdown, causing job losses. Although that sounds terrible, it is usually better than allowing inflation to get out of control, which can lead, in the extreme, to hyperinflation and the collapse of an economy. In an article we wrote recently, however, we noted that the US central bank’s approach to managing inflation may have contributed to structural biases against some members of the US workforce.
The relationship between employment and inflation seems sensible, and indeed it is a relationship that economists and investment practitioners rely on – explicitly or implicitly – every day. It gives us a reasonable framework and a good starting point for how to think about inflation and unemployment.
However, the relationship doesn’t always hold over all time periods. In fact, looking at the data going back decades, it actually doesn’t hold most of the time, especially over relatively short time periods. Importantly, over the last decade or so, the Phillips Curve has been fairly flat. By flat, we mean that as unemployment fell (as employment rose), inflation didn’t tend to increase much. That has meant that central banks have been less inclined to raise interest rates, which might sound like a good thing, until a crisis hits. When crisis hits, like last year, the central bank doesn’t have much firepower to reduce interest rates in order to encourage more inflation (and more employment). The reason they don’t have much room to cut interest rates is because they didn’t get a chance to raise interest rates during the ‘good’ times. Consider how low interest rates have been in developed economies like the U.K., Europe and the US since the last financial crisis in 2008.
So why is the Phillips Curve so flat? That’s not a question economists have managed to agree on an answer for yet. But there are some likely culprits.
One is technology. Remember how we said that if unemployment falls too low then in order to expand, companies end up raising wages to attract more workers? Well, not if they can use robots instead. By definition, technology increases efficiency and productivity. That means companies can expand without having to hire more workers. Through this effect, and also more directly, technology helps to lower prices in an economy, and is therefore referred to as being ‘disinflationary’ or ‘deflationary’. Think of the price (and quality) of TVs over the past 20 years or so.
Another factor at play is globalisation. Again, it might be the case that unemployment in a given country is extremely low, but then companies in that country can simply hire workers from abroad. Obviously, there are some restrictions to this, but globalisation has advanced considerably over the last few decades. In fact, entire industries full of workers in a given country have become unnecessary because the goods they were producing started to be imported from other countries instead.
Another culprit is demographics, and specifically the broad increase in life expectancy globally. This has led – in many developed economies at least – to increases in the old-age dependency ratio, which is a measure of the relative sizes of the working population and the retired population. As more old people depend on fewer working people, consumption in the economy falls and inflation falls. The demographic effect is not fully agreed upon, and the movement of labour across borders (globalisation) helps to offset it, but in many countries the effect is evident.
So, we find ourselves in a low inflation, low interest rate world, even during good times when employment is high. That is different from the past, but the trend has been evident for some time.
Despite the flaws of the Phillips Curve, the framework it gives us for thinking about how the world’s economy works remains helpful.
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