Tuesday, August 02, 2022

Lower Inflation Likely Requires Higher Unemployment; How High Is the Question

Quite high, if underlying inflation and the ‘natural’ unemployment rate have risen, some economists say

By Tom Fairless of The WSJ

One definition of the natural rate of unemployment is that it is the lowest rate of unemployment compatible with price stability (which the Fed defines as an annual inflation rate of 2% or less).

This graph shows that if we keep increasing AD (either by lowering interest rates, increasing the money supply or increasing government spending), Q (real GDP) will keep increasing which lowers the unemployment rate as firms need more workers. 

But the price level (CPI) will keep increasing more and more, meaning higher and higher inflation rates.

SRAS is short run aggregate supply. QF is the full-employment GDP (real GDP). When AD goes past AD2 (let's say we are at AD3 right now), we get significant price increases.

The big question to me is how much AD there is right now (although that is not the only question). If it is pretty far to the right, and well past QF, then AD will need to be reduced. But this would reduce Q or real GDP which means firms layoff workers, raising the unemployment rate. The more Q falls, the more the unemployment rate goes up.

But also, if workers continue to expect high inflation they will demand higher wages which reduces SRAS. Then we get both unemployment and prices rising. It would take another big reduction in demand to lower prices and that could put us below the QF.

Excerpts from the article:

"How much pain will U.S. workers need to endure if inflation is to return to 2%?

Not much, say most economists. Unemployment is expected to plateau near 4.3% at the end of next year, up from 3.6% in June, according to The Wall Street Journal’s latest survey of economists.

A great deal, according to other economists, who say unemployment might need to rise as high as 10%, implying a deep recession and much higher interest rates from the Federal Reserve."

"To get it to 2% (the inflation rate), the Fed will need to cool the labor market and lower wage growth (see above where I mention worker expectations and the shift in SRAS), currently running around 5% to 7% a year, according to data from the Labor Department and the Federal Reserve Bank of Atlanta.

That effort starts by reducing the number of job vacancies, which are currently historically high relative to unemployed workers. As the economy cools, companies will have less new business and start to withdraw job postings. 

As the number of job openings declines, unemployment tends to rise."

"In a paper published Friday, Fed governor Christopher Waller . . . argue[s] that unemployment might increase by only 1 percentage point or less, even with a large decline in the vacancy rate.

Vacancies are currently so high relative to available workers, the paper argued, that new job openings generate fewer and fewer hires. That means a given decline in vacancies will have a smaller effect on unemployment than in a normal labor market." (I think this is like saying we are not that far past QF in the graph and that Q is not that high because of the vacancies-jobs not getting filled so goods are not being produced)

"But other economists say that such a free lunch is unlikely.

Since the 1950s, every time the vacancy rate came down from a quarterly peak, it was accompanied by a significant rise in unemployment, according to a recent paper by former Treasury Secretary Lawrence Summers and former International Monetary Fund chief economist Olivier Blanchard.

For example, during the 2008 global financial crisis, the unemployment rate increased by as much as 3.8 percentage points. Since the 1950s, on average, the unemployment rate rose by 2.1 percentage points during the two years following a vacancy rate peak.

Moreover, the post-Covid economy may be less efficient at matching job seekers to job openings. That suggests a higher rate of unemployment might be needed, for a given number of vacancies, to stabilize wages and prices—a measure known as the natural rate of unemployment.

During the pandemic, jobs shifted geographically, especially out of city centers, putting them out of reach of some workers. Certain skills became more important, such as computer programming, while others were less in demand. The Fed can’t do anything to fix such mismatches between workers and jobs." (I think this means that SRAS has or will shift to the left since, if workers can't get hired, then we get rising prices and rising unemployment).

"If today’s high inflation rates have become deeply ingrained in the thinking of households and businesses, as they did during the 1970s, it will take much higher unemployment, and a punishing recession, to wring it out." (Again, see my comment on expectations above-also, from 1975-83 unemployment and inflation both averaged 7.7% and this is sometimes called stagflation)

Related posts:

Fed Focuses on Inflation Sentiment (Dec. 2021)

The Fed chairman says the relationship between inflation and unemployment is gone (2019)

Unemployment Isn’t What It Used to Be: The low rate doesn’t take account of low labor-force participation. Wages are a better indication of slack (2019)
The Phillips curve is alive and well (unless it's dead) (2019)


Fed officials disagree on how much inflation the current low unemployment rate might cause  (2018)

Fed Looks for Goldilocks Path as Jobless Rate Drops    (2018)

Is the Phillips curve affected by prices that are acyclical? (2019)

What is Full Employment?  (2020)

Jobs and Inflation: The Great Trade-Off, Demystified: The relationship between inflation and unemployment is real, but far from simple (2020)

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