by Jeffrey Kleintop, Senior Vice President and Chief Global Investment Strategist, Charles Schwab & Co., Inc.
- There has been a simple relationship between unemployment and inflation.
- If central banks move too aggressively in anticipation of a tightening global labor market reviving inflation, the impact of their actions on financial conditions could undermine the bull market in stocks.
- Global labor markets may now be at a point where wages may finally rise more rapidly.
Next month marks 59 years since economist William Phillips found a relationship between unemployment and inflation. It’s very simple: when unemployment is low, the competition for workers pushes up wages; higher wages mean higher costs for firms, which pass them onto consumers by raising prices. The opposite is true when unemployment is high.
This can be a very useful relationship for anticipating inflation, but there are two important things to note:
- The magnitude of the effect on wages is greater at lower unemployment rates. If the unemployment rate falls from 11% to 10%, this may only have a slight effect on supporting wages. But if it falls from 6% to 5% the effect on wages could be much greater.
- It only works over the medium-term, within an economic cycle. It does not work over the long-term across multiple economic cycles. Economist Milton Friedman explained that a government isn’t able to lower unemployment over the long-term by pushing up inflation and wages.
We can see wages and unemployment move in opposite directions during economic cycles and that they have both trended lower over time in the chart below of the 36 major countries tracked by the Organization for Economic Cooperation and Development (OECD).
Global unemployment and inflation
Inflation rate is the year-over-year change in the OECD Consumer Price Index.
The unemployment rate is for OECD developed countries.
Shaded areas represent major recessions for the OECD member nations.
Source: Charles Schwab, Organization for Economic Cooperation & Development (OECD) data as of 10/1/2017.
Technology has played a role in restraining wages and inflation, but unemployment is now at the point when inflation should be ticking up. The last three times unemployment was at this level, inflation started to rebound until cut short by a recession.
Although the chart shows inflation rising from 0.5% in 2015 to around 2% today, much of that rebound has to do with the bounce back in oil prices from the 2015 plunge. If there is no acceleration in wage growth, it is unlikely the recent rise in inflation can be sustained.
Why it matters
The U.S. Federal Reserve is trimming their balance sheet and raising interest rates and the European Central Bank is tapering their quantitative easing program. They are both taking these actions in anticipation of higher inflation brought on by more competitive labor markets. The financial markets seem to think they may be wrong and they won’t need to take these actions, based on what is priced into the interest rate futures markets. If central banks move too aggressively in anticipation of inflation, the impact of their actions on financial conditions could undermine the bull market in stocks.
The past three recessions were all caused by the bursting of bubbles: the housing bust led to the financial crisis of 2008-09; the collapse of dotcom stocks triggered the early 2000s recession; and the widespread bank failures of the Savings and Loan crisis preceded the early 1990s recession. But, unlike the last few recessions, the next one may end up being more like those of 1960s, 70s, and 80s. Those recessions were generally triggered by aggressive rate hikes.