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Inflation and Unemployment: What Happened to the Relationship?

Inflation and Unemployment—What Investors Should Know
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Kathy Jones, chief fixed income strategist at the Schwab Center for Financial Research, explains the link between unemployment and inflation in today’s economy.

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Janet Alvarez:
Lower unemployment usually comes with higher interest rates. But our current economic environment is different: While unemployment keeps declining, interest rates are still low by historical standards. It’s an unusual combination that has many investors—and economists—scratching their heads. In this installment, we’ll discuss what this means for the economy—and your wallet.

You’re listening to the Insights and Ideas podcast brought to you by Charles Schwab. I’m Janet Alvarez. The relationship between lower unemployment and higher rates is known in economic circles as the Phillips curve. Kathy Jones, senior vice president and chief fixed income strategist at the Schwab Center for Financial Research, joins us today to discuss the Phillips curve, and why it’s failing to describe today’s economy. She believes that investors should look beyond the Phillips curve to a number of other factors that might be impacting unemployment and inflation.

Janet Alvarez:
Hi, Kathy.

Kathy Jones:
Good morning.

Janet Alvarez:
Our segment today focuses on unemployment and inflation. That’s a big topic, but it’s also an important one given the economic trends of recent years. Can you tell us where the unemployment level is today and maybe a bit about how that compares on a historical basis?

Kathy Jones:
The unemployment rate today is around 4.7%, and that’s near the low end of the historical range. So the last time it was this low was around 2006–2007, when the economy was booming, and right before the financial crisis that struck in 2008–2009.

So typically it doesn’t fall much below about 4.5%. We’re getting very close to the low end of the historical range.

Janet Alvarez:
So if unemployment has been declining, that’s definitely a very good thing. But doesn’t lower unemployment usually also mean higher interest rates?

Kathy Jones:
Well, it has in the past. So what we’ve seen in the past is that, as unemployment falls—you know, more people are employed, they’re able to get higher wages; higher wages lead to more spending, and more spending typically leads to inflation. So there’s this relationship between unemployment and inflation where, as unemployment falls, inflation tends to pick up. And when inflation picks up, usually interest rates go up because the Federal Reserve starts to tighten policy to dampen down inflation pressures.

Janet Alvarez:
So this combination of low unemployment and low inflation is pretty unusual, no? Isn’t there usually kind of an inverse relationship between unemployment and inflation?

Kathy Jones:
Yeah. Typically we would have seen inflation start to pick up as unemployment fell over the past couple of years. It’s been falling at about 1% a year since the end of the recession, which is a pretty steady improvement. And at this level, you would typically start to see inflation pick up.

But right now, we’re not seeing a lot of it. We’re seeing just small hints of it here and there, but nothing significant. So it is a very unusual combination to have unemployment this low and inflation this low.

Janet Alvarez:
So in the simplest terms, what is the Phillips curve and what does it say?

Kathy Jones:
Sure. The Phillips curve actually originated with an economist in England many years ago who noticed this relationship between unemployment and inflation. And he plotted that relationship over time and saw that it was a curve. So as unemployment came down, inflation would start to go up.

And it’s called the Phillips curve because it’s named after the economist who discovered the relationship, or described the relationship, and his last name was Phillips.

But it generally says that as unemployment falls, inflation picks up. And it’s something that’s been a very important concept for the Federal Reserve and central banks in most of the world. They monitor it very carefully. And one reason job growth is so important to them is because of this relationship between inflation and unemployment.

So it’s a big concept in the world of economics, and it’s very big for central banks and particularly for the Federal Reserve.

Janet Alvarez:
That poses a little bit of a quandary. Why do the Phillips curve’s predictions seem off right now? What’s different about our current economic environment?

Kathy Jones:
Well, I think there are couple of explanations for it. And frankly, I’m not sure that everyone at the Fed really understands what’s going on right now, but there are a number of different theories. One is globalization.

So, although the unemployment rate in the U.S. is low, a lot of businesses have been able to outsource jobs to other countries where wages are quite low. Obviously China and Mexico, places where you could ship manufacturing activity and get much lower wages.

A second reason is that workers simply have less bargaining power these days than they might have in the past. So if you look at the Phillips curve back in the ’50s, ’60s, early ’70s, unionization was much higher as a percentage of total workforce, and unions were able to negotiate better wages for their workers.

And then there’s the last theory, which I think is also a potential explanation. And it’s that the conventional unemployment rate really may not be measuring the available pool of workers. So if we look at 4.7%, that would imply that there’s really a very small pool of unemployed people for companies to draw on when they’re hiring. And it may be the case these days that that pool is actually bigger and we’re not measuring it as well.

So one of the numbers that I like to track is the labor force participation rate. That’s just how many people are actually participating in the workforce. And that’s been quite low since the recession. And it has really not picked up very much, even for people in the prime working age of 25 to 54.

And that says there’s probably a lot of people on the sidelines that we’re not counting. So the ability of employers to find workers outside of what we’re conventionally measuring may be greater. And so the Phillips curve may not be reflecting the actual availability of workers if we use the conventional unemployment report.

Janet Alvarez:
So if other factors such as global trade, globalization of labor, as you mentioned, are having an impact on the Fed’s decision-making, does that mean that the Phillips curve should be discounted entirely?

Kathy Jones:
Oh, I don’t think so. And based on what the Fed tells us, they’re still looking at it. They’re still very cognizant of wage pressures and the unemployment rate, but they’re really looking at a larger number of measures.

Janet Alvarez:
For the first 15 years after it was introduced in 1958, the Phillips curve was considered a rule of thumb for the economy. That’s one reason the recession that lasted from 1973 to 1975 was such a surprise. It differed from previous downturns in that it was a period of both high inflation and unemployment. The experience led to the popularization of the term “stagflation” to describe stagnant growth coupled with high inflation. That development is the polar opposite of the current economy, which is marked by both very low unemployment and very low inflation.

So let’s move on to this idea that unemployment, inflation and rates are all low. That does sound like a bit of a golden trifecta. But what you’re saying is that in this environment, it isn’t necessarily that the statistics aren’t capturing it accurately, and so it’s less favorable of an environment than investors might normally expect?

Kathy Jones:
Well, I think there are a lot of question marks around it. It’s an environment that’s good for borrowers because the interest rates are quite low, because inflation is low. So if you’re borrowing money for a mortgage, or a car loan, or if you’re a company looking to borrow money to expand your business, it’s a good environment for you.

But if you’re a saver looking for higher interest rates, or you’re looking for the economy to really be stronger, which is what the Fed would like to see, then it’s not so great.

So I think that there’s a bit of a mystery in terms of policy right now. Where is that sweet spot where we start to see wages pick up, where the Fed can bring interest rates back to a more normal level that we’ve experienced in the past? And all that really depends on the economy picking up at a stronger rate, and it just has been a very sluggish pace of growth since the end of the recession in 2010.

And I think that the bottom line for the Fed is they just want to see that economic growth pick up, and that would be good for all of us, even if it means somewhat higher interest rates.

Janet Alvarez:
So in your opinion, is our current economic environment likely to persist? Is this a scenario where the Phillips curve will come back into play at some point?

Kathy Jones:
Well, I think that we could see a kind of slow-growth, low-inflation environment, and a low-unemployment environment for a while still. But I think eventually it comes back. At some point or another, especially with the baby boomers retiring and leaving the workforce, the pool of available workers is going to get pretty small, or it’ll get tight.

And at that point, we should see more bargaining power for workers relative to employers. And that should start to translate into higher wage growth and more purchasing power for households. And once you get that purchasing power up for households that tends to spur economic growth.

So I’m a believer that the Phillips curve will come back into play, that we’re probably just not there yet, but we will get there sooner or later, barring a recession or some other outside influences. As long as we can continue to see the economy grow and continue to see the unemployment rates fall and get people back into the workforce, I think the Phillips curve will continue to be a valid measure for policymakers and economists going forward.

Janet Alvarez:
Kathy, thanks very much for joining us today.

Kathy Jones:
Thank you.

Janet Alvarez:
The Phillips curve is more than just an academic theory. It has influenced policy decisions around inflation and unemployment worldwide to differing degrees since the 1960s. Al Broaddus, president of the Richmond Federal Reserve bank from 1993 to 2004, once said of the Phillips curve that “it’s in the woodwork, in the infrastructure.” A handful of economic environments that have defied the Phillips curve, especially in the 1970s and ’80s, and it faced strong criticism by Nobel Laureate economists Edmund Phelps and Milton Friedman. As a result, most central bankers and economists now believe that the Phillips curve alone won’t explain or predict all movements in inflation and unemployment. Those critiques, along with the lessons of the past, resulted in what’s called the expectations-augmented Phillips curve, which factors in a number of other variables. This model serves as a fundamental element in the macroeconomic forecasting framework used by most governments and businesses around the world.

Kathy Jones is the senior vice president and chief fixed income strategist at the Schwab Center for Financial Research. She’s on Twitter @KathyJones, K-A-T-H-Y-J-O-N-E-S. That’s it for this installment. The Insights & Ideas podcast is brought to you by Charles Schwab. You can find us on iTunes or Thank you for listening.

Important disclosures

All expressions of opinion are subject to change without notice in reaction to shifting market, economic or geopolitical conditions.

Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed. Supporting documentation for any claims or statistical information is available upon request.

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This podcast was recorded in July 2016. As of August 2016, the unemployment rate has since risen slightly to 4.9%.

Please note that this content was created as of the specific date indicated and reflects the author’s views as of that date. It will be kept solely for historical purposes, and the author’s opinions may change, without notice, in reaction to shifting economic, business and other conditions.


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