The Great Divorce: Inflation and Unemployment

By James Dail (CMC ’20)

When the great recession ended in June 2009, something unusual began to happen to the US economy. Both the unemployment rate and the inflation rate were simultaneously low, which is unusual, as they are never supposed to occur simultaneously. While having both a low unemployment rate and inflation rate is great news for Americans,this phenomena represent the break down of one of the most basic economic models, and economists are baffled over why it is happening.  

The Phillips Curve is one of the standard models of macroeconomics. It essentially demonstrates that the unemployment rate and the inflation rate are negatively correlated with each other. Once the economy starts growing, and the unemployment rate begins falling, then the inflation rate must rise. This means that, whenever there is low-unemployment, it will be coupled with a high rate of inflation. The Phillips Curve has traditionally played a very large role in where the Federal Reserve decides to place interest rates. One of the Federal Reserve’s primary tasks is to keep both the unemployment rate and the inflation rate low. Whenever the economy began growing too aggressively, and inflation started to get out of hand as a result, the Federal Reserve would step in to raise interest rates in order to slow down economic activity to ensure that inflation remained low. That this is not happening, and that the Federal Reserve has accomplished its main tasks of low unemployment and inflation, is great for American economic well being. However, a full break down of the model also carries significant risks for future economic crises. Before this, the Federal Reserve confidently knew how to control inflation were it ever to get too high. That is no longer the case, and it is necessary to know what went wrong with the Phillips Curve model in this instance in order to regain this understanding.

There are several possible explanations for why current economic conditions are not adhering to the Phillips Curve. The first is that the traditional unemployment rate has become a flawed metric for identifying how many people are actually unemployed. When the Congressional Budget Office computes the unemployment rate every month, one of the questions it asks those it surveys is if they are currently searching for a job. If the answer to that question is no, then those individual are marked as not participating in the labor force and are left out of the unemployment rate calculation. This means that if workers are discouraged enough from an extended bought of unemployment to stop looking for a job entirely, then they will not be picked up by the unemployment rate. If this is true, then the unemployment rate is no longer a strong indicator for economic strength. There is some data to back up this assertion, as the labor force participation rate has declined significantly since the beginning of the Great Recession, indicating that some working age people might have simply stopped looking for work. The alternative explanation is that the Phillips Curve has broken because of globalization. The expansion of the global labor pool has allowed goods to be produced cheaply in other countries, and then imported to the United States. The idea here is that this influx of cheap goods has kept prices low and eased inflationary pressures. If true, this could explain more than just persistent low inflation, but the lack of wage growth in the economy as well.

Whatever the cause of the Phillips Curve breakdown, it is imperative that policy makers understand the forces that are at play behind it. If the Federal Reserve has a limited understanding of what drives inflation in the modern economy, then they might not be able to control a future inflationary crisis. A more contemporary example is that if inflation is destined to persistently remain low, then it might have been advisable for the Federal Reserve to keep interest rates low for a longer period of time after the Great Recession ended. Both of these possible solutions should be examined so that a new and accurate economic model may be produced.

 

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