In economics class, they teach that inflation and unemployment have an inverse relationship...but what if that's not holding up anymore?
When economists pull out their stethoscopes - I mean… spreadsheets - to do a health check on the economy, they look at a number of factors. But the two biggest indicators are inflation and the unemployment rate.
Inflation and unemployment aren’t related but they do tend to have an inverse relationship…most of the time.
So what does that mean? Well, when inflation is high (like right now), unemployment tends to be low (at least there’s a bright side…?).
But when inflation is low (like the good old days), unemployment tends to be high (oh…sigh).
But the relationship between them is a little more complicated than that, so let’s piece it together.
How the inflation rate affects the economy:
Inflation reduces your purchasing power - meaning that when we experience inflation, the same amount of money buys you less stuff.
When inflation is high, those Red Rock Deli chips jump from $4 to $6. It huuuuurts. And it’s not sustainable. If we don’t put a stop to this, those delicious chippies will be $12 before we know it.
So the RBA has been raising the cash rate so that life becomes more expensive for individuals and businesses - ultimately leading people to spend less so that inflation calms TF down.
But, how does that all impact the unemployment side of things?
How the unemployment rate affects the economy:
The unemployment rate measures the percentage of people in the labour force who are ready and willing to work but don’t have a job.
Economists look at this figure to get an idea of how strong and healthy the economy is; kinda like checking the economy’s blood pressure.
So, when the economy is strong, glowy and living its best life, unemployment is low, and major growth is happening.
But because of the tight labour market, employers have to compete for workers, which can drive up wages. And this growth in wages can increase inflation. And that explains why your sub-standard co-worker is being paid more than you.
Whereas if unemployment is high, this can have a cooling effect on prices, potentially reducing inflation.
Soo….high inflation leads to low unemployment and low inflation leads to high unemployment?
A famous economist, A.W Phillips came up with the theory that there’s an inverse or opposite relationship between unemployment and inflation, and his theory is called the Phillips curve. You’ve gotta name your economic theory after yourself, right?
Now, his theory poses a sticky situation for economists and policymakers because it basically implies that as the RBA increases the cash rate rise, it is likely going to put people out of jobs.
But economists aren’t so sure that the Phillips curve is always accurate, especially in the developed world.
In the years leading up to the pandemic, inflation was low and unemployment and wage growth was the slowest it’s ever been.
And after the pandemic, we’ve seen the job rate remain pretty solid and prices absolutely shoot for the sky.
Soooo instead of moving in the same direction, inflation and unemployment were both easing.
With enough pressure on inflation, through rising interest rates, the inverse relationship between unemployment and inflation probably will play out eventually.
And it’ll come at a major cost - jobs.
What are economists going to do next?
So far, the RBA has been laser focused on upping the cash rate to bring prices down.
But, they’ve been getting some backlash from other economists, and policymakers who are saying it’s time to try another approach.
Especially because continuing to push up interest rates aggressively could lead to some massive layoffs and possibly have us thrown into recession.
But it looks like the RBA is heeding the warning as this month they’ve put a pause on interest rate rises FINALLY after almost a year of back to back raises.
History has taught us a lot about what to do and what not to do, but if raising interest rates could come at a serious cost to jobs, it looks like it’s time for the RBA to go back to the drawing board.
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