Federal Reserve, assessing inflation-unemployment link, faces an inflection point

Remember 2022? The economy was recovering from the COVID-19 pandemic, companies were posting new jobs left and right and job seekers could take their pick. It felt like a good time to be a worker.

It was also when annual inflation peaked at over 9%.

“The labor market was very frothy. We had high inflation, and there was just a lot of churn,” said San Francisco Federal Reserve President Mary Daly.

So, the Fed raised interest rates — 11 times in 2022 and 2023. That’s helped to bring the inflation rate far closer to the Fed’s goal of 2%.

Meanwhile, the number of U.S. workers collecting unemployment benefits ticked up to 1.84 million last week. It’s the highest level since November 2021. 

So now, the Fed faces a turning point: Cutting interest rates could help the slackening job market, but it could also hinder its goal of lowering inflation. This theory, that inflation and the job market are connected, has a name. It’s called the Phillips curve. Economists have used it to study this relationship and predict its movement since the 1950s. It tells us that as the Fed tries to cool inflation, it cools the job market too.

“We have two mandated goals: price stability [and] full employment. For the longest time, inflation has been the focus of our hiking campaign. Now, as we monitor the economy, we have to look at both sides of our mandate,” Daly said. “We’re almost to the point where we’ve taken away all the vacancies that were posted in that very frenzied time in the labor market.”

Fewer job postings isn’t necessarily a huge problem. It gets dicier when employers run out of vacancies and start resorting to layoffs. It’s why unemployment has slowly crept up. That’s the inflection point the Fed has reached.

But the rising-unemployment scenario isn’t set in stone.

So far, the unemployment rate has risen only slightly in the time it took inflation to fall significantly. (Courtesy San Francisco Fed)

“Over time, the relationship has kind of deteriorated,” said Brian Jenkins, an economics professor at the University of California, Irvine. “In recent years, there’s been very little relationship between movements in the unemployment rate and movements in the inflation rate.”

There are two big reasons for that. No. 1: The guesswork has improved.

Once upon a time, in the 1950s, companies would guess where the inflation rate was headed and set prices and job postings based on those guesses. Sometimes, they would exacerbate whatever trend those companies thought they were seeing.

“Current inflation depends on expectations about the future,” Jenkins said. “It’s just that now, we have a better idea of what to expect from the future because the Fed is doing a better job of having a goal and then telling us what they’re trying to do.”

No. 2: Our jobs now are different from the jobs of the ’50s.

“In that time period, we had a very manufacturing-based economy, and now we have a highly service-based, financialized economy,” said Peter C. Earle, a senior economist with the American Institute of Economic Research.

When the economy would slow, often accompanied by easing inflation, we’d manufacture less stuff, he said, and we’d need fewer people to make the stuff. Modern service economies — and the causes of unemployment in those economies — are driven more by shifts in structure or technology, like artificial intelligence or self-checkout aisles replacing grocery cashiers.

Earle said all of this makes cooling inflation without sacrificing lots of jobs easier than it used to be. Look at 2019: Inflation and unemployment were lower than they are now. Earle said now that we’ve reached this inflection point, he’s not ready to say whether the recent unemployment increase is just a stutter step or a more serious trend.

“We’re not exactly sure where things are going to go,” Earle said.