Unemployment, Labor Costs, and Recessions: Implications for the Inflation Outlook

Article excerpt

Economists have been arguing about the connection between unemployment and inflation for decades. Critics claim that the connection is unreliable and leads policymakers astray, while others argue that the relationship is useful for forecasting. We examine the more direct connections between elevated unemployment levels and the rate of increase in wage and labor costs, more generally. We find that wage and labor cost growth has declined markedly following recent recessions. It has again declined sharply in the most recent recession. We also find that compensation typically remains subdued during the initial phases of recent recoveries. This is again the case in the current recovery, making labor costs a significant restraining force on inflation going forward.

It is logical to assume that today's unemployment rate is high enough to influence the compensation of workers who find themselves competing with millions of other unemployed people for die samejobs. This connection between real economic activity and prices is what economists refer to as a "Phillips curve," which, despite how reasonable the relationship seems, has been extensively criticized as unreliable.

One criticism concerns the use of the Phillips curve relationship as a basis for monetary policy, since the curve could suggest that a tradeoff between inflation and unemployment exists. The existence of such a tradeoff could mean that causing an increase in inflation will lower unemployment. Two notable critics ofthat idea, Nobel prizewinners Edmund Phelps and Milton Friedman, first argued in the late 1960s that any tradeoff between inflation and unemployment would exist only in the short run; once the public expected higher inflation in the future, the effect would disappear. Thus, expansionary monetary policy leads to more inflation rather than a decline in the unemployment rate. This critique aptly describes the Fed's policy errors during the 1970s, which many critics of current monetary policy fear are being repeated.

More technical limitations to the Phillips curve have also been noted. In particular, the forecasting performance of various forms of the Phillips curve has been shown to be unreliable in certain time periods. In the extreme, economists have argued that in recent time periods ". . . Phillips curves are not useful for forecasting inflation." This is not a mainstream conclusion particularly among economic forecasters, but the instability of the relationship is widely recognized and is a real challenge for central banks.

Conversely, a recent paper by James Stock and Mark Watson argues pretty convincingly that "U.S. recessions are associated with declines in inflation." In their work, Stock and Watson use a time-scaling technique to compare increases in unemployment and declines in inflation over business cycles. Using the time scaling technique, they are able to compare similar points in time during business cycles of various lengths. Their results point to a more stable relationship between the rise of unemployment in recessions and lower subsequent trend rates of inflation.

In order to focus a little deeper on the underlying response of labor costs to unemployment, we explore the connection between elevated unemployment levels and the rate of increase in labor costs, using Stock and Watson's technique. We conclude that labor cost growth has already declined markedly, and labor costs are likely to be a significant restraining force on inflation going forward. Furthermore, the patterns of past recessions indicate that most of the decline in labor cost growth may have been already realized.

Ultimately, we will have to look back on the next couple of years of data to see how influential elevated unemployment rates were on the inflation process, but in the meantime, economic projections for inflation have to be guided by something. At the very least, projections must assume an implicit view on the question of what effect unemployment has on compensation growth and inflation. …