The relationship between inflation and unemployment has changed | Chroniclers
If you want to be remembered in economics, get yourself a curve. There is the Lorenz curve, the Laffer curve, the Kuznets curve and, probably the most famous, the Phillips curve. Phillips was AW Phillips, a New Zealand economist who worked in London. In 1958, he drew a curve connecting the points between inflation and unemployment. When unemployment fell, inflation rose. The Phillips curve has taken the economics profession by storm.
Sometimes people love your curve so much that it becomes law. This is what happened to Arthur Okun. He drew a curve showing the relationship between growth in inflation-adjusted gross domestic product and changes in the unemployment rate. When “real” GDP has grown sufficiently, unemployment has fallen. Okun’s colleagues in the Kennedy administration liked it so much that they called it “Okun’s Law”.
The problem with curves and laws in economics is that they don’t stay put. The relationship between inflation and unemployment has changed since the days of Professor Phillips. The relationship between real GDP growth and unemployment follows a different law from that in Okun’s time. We have learned a lot about these changes during this long expansion of the past decade.
Okun first. From the 1980s to the 2000s, it took about 3% of real GDP growth to keep the unemployment rate from rising. If growth were to slow, the unemployment rate would rise. The reason is that the number of people who want to work is constantly increasing. Young people graduate and look for a job. Many more women entered the workforce during most of this period. Real GDP must have grown fast enough to create jobs for all of these people.
Young people are still graduates in their twenties. But many baby boomers have started to retire, and women’s participation in the labor market has stopped increasing. Instead of increasing by 1.3% per year, the average growth of the labor force was only 0.4% per year. As a result, real GDP only had to grow half as fast to keep the unemployment rate stable. Faster growth caused it to fall.
This is what happened during the expansion. Real GDP growth averaged only 2.3% per year from 2010 to 2019, and only exceeded 3% once. The unemployment rate nonetheless fell from 9.6% to 3.7%.
The last time the unemployment rate was this low was in 1969. That year the inflation rate was 5.8%. Inflation was below 2% in the early 1960s, but started to rise once the unemployment rate fell below 5% in the middle of the decade. Falling unemployment led to higher inflation, as predicted by the Phillips curve.
Inflation was also below 2% for much of the first half of the 20 years. So what was the inflation rate at the start of 2021, when unemployment hit 3.5% for the first time in 50 years? Only 2.2%. No problem.
The Phillips curve appears to have flattened. Unemployment is falling and inflation is rising, but only a little. Maybe not enough to make a difference in people’s lives.
We are trying to get out of the COVID recession. Once the virus is under control, we want companies to start hiring so that the unemployment rate can drop to 6.3% in January. The Federal Reserve will keep interest rates low to encourage borrowing and spending. The federal government could pass a big spending bill, to give businesses more reasons to manufacture products and hire employees. Real GDP will grow faster – hopefully much faster than the 1.5% growth needed to bring the unemployment rate down.
The cost of a low unemployment rate is a rise in inflation. But with a flat Phillips curve, this cost is quite low. We could push the unemployment rate towards the low 3s without raising inflation enough to matter. Good things happen when the unemployment rate is really low. People find work more easily. Salaries tend to increase.
Past performance is no guarantee of future results. Your mileage may vary. No animal was injured during the writing of this column. But our most recent data on real GDP growth, unemployment, and inflation indicate that we can lower the unemployment rate without raising inflation much. Maybe Okun and Phillips would approve of this post.
Contact Larry Deboer, professor of agricultural economics at purdue university, at [email protected]