Rate Watch #1272 – Does Low Unemployment Necessitate Inflation.

September 21, 2020

by Dick Lepre




Last week I discussed the Fed’s dual mandate: low unemployment and low inflation. It has been made clear by the Fed that if it cannot achieve these simultaneously in the next couple of years it will direct policy so as to keep the unemployment rate low even if inflation get above the desired 2%. This has caused some anxiety because there was a log-time belief that low unemployment causes a higher than desired level of inflation.

NAIRU - If It Exists, What Number Is It?

NAIRU stands for "Non-Accelerating Inflation Rate of Unemployment." It means the lowest rate of unemployment which leaves inflation constant. 

Lurking behind NAIRU is something called the Phillips Curve. https://www.econlib.org/library/Enc/PhillipsCurve.html. Having analyzed data from 1861 to 1957 British economist A.W. Phillips published a paper in 1958 that noted that when inflation was high in Britain, unemployment was low. The relationship made sense. It assumed that as unemployment got low, workers could and would demand higher wages and inflation would result.

NAIRU concentrates on the unemployment rate as a prelude to inflation. For years it was believed that an unemployment rate falling below 5%-6% would trigger inflation. 

Before we trash NAIRU, let's try to understand in what sense there is some truth in it. NAIRU is the inflation-safe rate of unemployment. That is, once unemployment falls to NAIRU and GDP continues to increase inflation is necessarily a consequence. This sounds reasonable and may indicate that NAIRU does or did exist. But, if it does exist, it certainly is not as large as 6% or even 5% or even 4%, As late as 1993 it was the position of the Fed that NAIRU was 6% or greater. 

The fallacy of NAIRU, then, is not in believing in it but in the simplistic notion that it is some quantifiable constant or even "fuzzy constant." NAIRU has failed because the unemployment rate is no longer a valid predictor of inflation. There have been a lot of small but contributory factors which have caused the non-acceleration of inflation. Among them are:

1) Weaker labor unions. 

2) Employers have discovered that contract and temporary employees do not have the bargaining clout to walk into the boss's office and say: "Hey, I want a raise". In addition, such workers do not get the usual job benefits. "Capitalism is getting meaner" suggests Princeton University economist Alan Blinder. 

3) The global economy. No matter how low the domestic unemployment rate falls there is unemployment and excess plant capacity abroad. Low-priced products from abroad keep domestic inflation tame both in fact (stuff is cheaper) and implicitly - workers are forced to tame their demands for wage increases for fear of pricing the product of their work above what the market will allow. In addition we have seen in the computer software business the importing of skilled, lower-cost labor. The work did not go abroad, the workers came here.

4) Technology. Technology has increased worker productivity. The expanding impact of the internet provides the consumer with more information and more competitive prices on things such as cars, books and even mortgages. The internet has helped contain inflation. 

Let's assume that NAIRU does exist and that it was once 6% but due to changes in the structure of the economy has fallen below 4%. What has it fallen to or near? Should the Fed hike rates out of a belief that 1) NAIRU is real 2) it must under 4.0% and 3) a preemptive strike against inflation in the form of a Fed funds hike is, if not necessary, at least desirable. Or should the Fed leave the darn thing alone until NAIRU makes a better case for its existence.


The correlation between inflation and unemployment is not as strong as it once was or perhaps it was never as strong as believed.

No conclusions should be drawn about how important NAIRU is or the hypothecation of its value. Powell said that it does exist but is a lot lower than previously thought. I don’t see this as an indictment of economists or the Fed. The fact is that the economy is extremely complex and also dynamic. If no one knows what an accurate value of NAIRU is then it is useless as a policy tool.

In choosing to drive down the unemployment rate even if inflation grew the Fed made a humane and economically sound decision. 

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A recap of last week's fundamentals is here.


Technical Analysis from Jim Grauer

 Expect the 10-year Note to trade in the 0.55%-0.85% range.

Detailed stochastic analysis is here http://www.loanmine.com/CustomPage378.x

 Dick Lepre
 Senior Loan Advisor

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