Jun 05, 2017

The Curious Puzzle of Low Inflation Amid Falling Unemployment

By Gene Balas

In economics, the textbook theory known as the Phillips Curve is that low unemployment should drive inflation higher, as companies might need to possibly offer higher wages to attract talent from a smaller pool. You’ll note that I’ve caveated that sentence with “might” and “possibly”, and for good reason: Many economists are puzzled why higher inflation hasn’t happened recently, with the drop in the unemployment rate to 4.4%.

Unemployment is considered low and in the region where inflation might theoretically ignite by now, yet inflation is dormant. Recall that the Fed’s inflation target is 2%, and the economy has struggled, unsuccessfully, to achieve that target, as seen in the nearby graph. Inflation is a bit like blood pressure: we usually think of too high inflation as being the only problem, but too low inflation can be a symptom of fundamental weakness in the health of the economy.

PCE Inflation.png

A different way to think about wages and inflation

There is a different way to think about wages and inflation. Consider wages and salaries as a share of gross domestic income – the total income received by all individuals and entities, such as corporations, in the country – and then compare this proportion to that of corporate profits as a share of GDI. (These data are from the Bureau of Economic Analysis and the Bureau of Labor Statistics, as published by the St. Louis Fed.)

When workers have the upper hand, they can command a relatively greater share of the national income, and when this ratio falls, corporate profits are growing faster than are wages. This ratio is generally higher when unemployment is low and vice versa. However, wages relative to corporate profits (the red line in the nearby graph) have not accelerated in the recent recovery and expansion, despite falling unemployment, in the blue line in the nearby graph.

Wages to Profits vs Unemployment.png

It is also instructive to compare this ratio of the share of national income going to labor vs. that going to corporate profits to the Bureau of Labor Statistics’ consumer price index, with data going back to 1950. From 1950 through the mid-1980s, you’ll observe in the nearby graph how there has been a tight relationship with inflation (the red line) being higher when labor compensation occupied a greater proportion of gross domestic income (the blue line).

Wages to Profits vs Inflation.png

In other words, companies responded to paying higher wages by raising prices. (You’ll also note that the peaks in this series occurred just before a recession, as the Fed presumably reacted to higher inflation by tightening monetary policy, potentially causing a recession.)

What factors are at play?

After the mid-1980s, this relationship broke down. You may recall that the Fed tightened monetary policy aggressively up to and during the early 1980s to break the back of rampant inflation, and it succeeded in that regard.

There were a few other factors, too, however. These included the widespread introduction and acceleration of computing power, offshoring of positions, automation of tasks, and decreased unionization of the workforce. These all kept costs down, helping to ameliorate inflation pressures, and these trends have continued since then.

The current environment

In fact, going to the chart above, you’ll note that the relationship between a higher proportion of national income going to labor and inflation – which was strong from 1950 to the mid-1980s – virtually ceased to exist in the past few decades. Importantly, observe that the peaks of the ratio of labor income vs. corporate profits have been consistently lower from one cycle to the next. And more to the point now, the lows in that graph have also been lower in each successive cycle. Disinflationary trends have been a headwind to wages, and have also kept overall prices from rising by much.

Indeed, the share of income going to labor vs. corporate profits steadily decreased and is now at the bottom of the range in data going back to 1950 – and inflation is also near the bottom of that range. This is despite the fact that the unemployment rate also steadily dropped since the mid-1980s up to the mid-2000s. We have both falling unemployment and a lack of pricing pressures.

This brings us to questioning why inflation isn’t picking up when unemployment has fallen, and why past relationships no longer seem to hold true anymore. There are probably many different causes, and it is hard to quantitatively define the current lack of a wage-price relationship.

The monetary policy dilemma

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Monetary policymakers are struggling to understand the changing nature of the economy – and it is a global phenomenon across the developed world. Fed Governor Lael Brainard spoke recently about inflation and unemployment, and she shared a few of her views.

“I see some tension between signs that the economy is in the neighborhood of full employment and indications that the tentative progress we had seen on inflation may be slowing,” Brainard said. “If the tension between the progress on employment and the lack of progress on inflation persists, it may lead me to reassess the expected path of the federal funds rate in the future, although it is premature to make that call today.”

What does that mean for interest rates and monetary policy? If low unemployment isn’t stoking inflation, and if inflation isn’t responding to low interest rates, perhaps the economy simply needs a lower “neutral” interest rate to continue to foster that low rate of unemployment. The neutral rate is the rate where inflation and unemployment neither increase nor decrease, and the economy is in a steady state. Brainard continued, “I do believe that the neutral rate is very low, that we are not far at all from neutral, and I don’t have a strong amount of confidence that it’s going to rise rapidly from where we are today.”

The upshot is that we may have low interest rates long into the future, as the economy might not be able to tolerate higher rates – nor need them to curtail inflation.


So, the main point of this exercise is that past relationships haven’t held true in recent years, and the trend began some years ago. The causes of low inflation and, as we’ve seen in a related discussion, the declining share of income going to labor vis-à-vis corporate profits, are mysteries that have stumped economists.

Most likely, there are a number of contributing factors – technology, automation, offshoring, lower rates of unionization, and just the plain old fear of asking for a raise given a widespread perception of job insecurity. These all appear to be beyond the scope of monetary policy. What we might expect, though, is for low rates to continue to be low, even with low unemployment. After all, Japan’s unemployment rate has been low for many years, according to data from the Organization for Economic Co-operation and Development – and it has yet to experience an uptick in inflation, according to data from the World Bank, no matter how hard the Bank of Japan might try to drive inflation higher, even with sometimes-negative interest rates.

Perhaps sometimes textbooks were made to be rewritten.

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Gene Balas

Gene Balas

United Capital Financial Advisers, LLC (“United Capital”), is an affiliate of Goldman Sachs & Co. LLC and subsidiaries of the Goldman Sachs Group, Inc., a worldwide, full-service investment banking, broker-dealer, asset management and financial services organization. Investing involves risk and clients should carefully consider their own investment objectives and never rely on any single chart, graph or marketing piece to make decisions.

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