Does Low Unemployment Signal A Meaningful Rise In Inflation?

from the St Louis Fed

— this post authored by James Bullard

The unemployment rate in the U.S. is relatively low by recent historical standards. Some people argue that this means higher inflation is just around the corner, which they cite as a reason for the Fed to raise the U.S. policy rate (i.e., the federal funds rate target). In my view, however, low unemployment readings do not appear to be an indicator of substantially higher inflation to come.

Arguments that low unemployment will translate into high inflation are based on the so-called Phillips curve, which suggests that a negative relationship exists between the two variables. This relationship has been in the middle of central banking debates since the 1958 paper by the late economist A.W. Phillips. The Phillips curve dramatically fell out of fashion in the 1970s, when both high unemployment and high inflation gripped the U.S. economy and much of the rest of the world. In the inflation-targeting era that began in the 1990s, however, Phillips curve arguments have returned and have again been important in central banks’ decision-making.

But how robust is the relationship between unemployment and inflation in the data?[1] In a recent analysis, economist Olivier Blanchard estimated a Phillips curve relationship for the U.S.[2] The general finding was that the statistical relationship between unemployment and inflation is much flatter today than it has been historically.

Table 1

Estimated Influence of Unemployment on Inflation

SOURCES: Bureau of Labor Statistics, Bureau of Economic Analysis and author’s calculations based on Blanchard. See the second endnote.

* The first row contains the latest values for unemployment (July 2017) and inflation (June 2017). The inflation rate is measured as the year-over-year percentage change in the core personal consumption expenditures price index (core PCE).