LABOR IS A TERRIBLE GUIDE TO INFLATION, BUT NOBODY WANTS TO ADMIT IT / THE WALL STREET JOURNAL

Labor Is a Terrible Guide to Inflation, but Nobody Wants to Admit It

Though central banks, economists and investors are attached to employment figures as predictors of inflation, this year’s experience suggests it is time to downplay them

By Jon Sindreu

Western labor markets are now starting to cool, but were still extremely tight earlier in the year, as inflation was coming down from its peak. PHOTO: Jordan Vonderhaar/Bloomberg

In a world of volatile commodity prices, clogged supply chains and government stimulus checks, the tightness of the labor market seems to be the only guide central banks really trust in their push to steer inflation below 2%. 

Unfortunately, it is a compass that rarely points north.

Since U.S. data for August showed a cool-down in hiring and wages and an increase in unemployment, financial markets have all but excluded the possibility that the Federal Reserve will keep raising interest rates. 

Combine this with a big fall in inflation this year, and it might look like a rehabilitation of the traditional economic theory that links a looser labor market to weaker pay demands, and hence to slower price growth.

But the timing doesn’t make sense: Looking at 17 rich nations, the big drop in inflation happened earlier, when unemployment in half of them was falling or unchanged. 

In fact, declining inflation shows no correlation with rising unemployment across countries, neither before inflation peaked nor after. 

Western labor markets were as tight before the pandemic, when inflation was dormant, as in 2021, when it took off.

Does this mean central banks haven’t had much impact? 

Perhaps, though their actions may take longer to play out. 

Rather, the lesson here is that, whatever hand monetary policy had in slowing the economy, it isn’t what lowered inflation.

Case in point: The eurozone economy severely disappointed analysts’ expectations this year even as the U.S. economy exceeded them, yet inflation overshot those same forecasts in both regions.

Or take German core inflation, which came in unchanged last week at 5.5%, despite the economy failing to expand and unemployment ticking up. 

This makes it hard to guess whether the European Central Bank will raise rates for a 10th consecutive time in September. 

Hawks emphasize that the jobless rate is still at historically low levels and that German wages increased at a record 6.6% in the second quarter. 

Doves rightly say that much of the extra pay came from one-offs.

So far, though, wage growth in the eurozone has always followed consumer-price growth, not preceded it. 

The link with unemployment is even more tenuous.

Yet neither doves nor hawks seem willing to admit this. 

Ever since William Phillips unearthed his famous “Phillips curve” relationship in U.K. data in the 1950s, it has been enshrined in economic discourse. 

The notion that policy makers could exploit this trade-off lost traction following the “stagflation” of the 1970s, but central banks have held on to some form of “output gap” as an explanation for inflation.

Recently, prominent economists have argued that the best measure of economic slack isn’t the jobless rate, but the ratio of job openings to unemployed people. 

It hasn’t really worked out. Former White House adviser Larry Summers, who correctly warned about inflation in 2021, co-wrote a paper last year predicting that a 1.5 ratio would lead to a surge in wage growth. 

The ratio actually ended up much higher than 1.5 for much of this year, yet pay has still decelerated.

Similarly, former International Monetary Fund chief economist Olivier Blanchard underscored that, based on historical data, a normalization of vacancies would imply a lot of job losses. 

This hasn’t materialized either. 

A better spin on this was put forth by Pierpaolo Benigno and Gauti Eggertsson, who argued in a working paper earlier this year that a strong positive correlation between inflation and the vacancies-to-unemployed ratio only kicks in above a certain threshold when openings truly outpace job seekers. 

Fed researchers said a similar thing in July.

This could explain recent developments in the U.S.: A very slight cooling in the economy may have been enough to bring down vacancies sharply, and perhaps help lower inflation in the process.

Still, it doesn’t explain why inflation has behaved similarly in Europe, where there are far fewer openings per jobless person. 

In a speech Thursday, ECB rate-setter Isabel Schnabel suggested that the threshold there may be lower.

“There is no single Phillips curve but a set of different curves pointing to different paces of disinflation across sectors and countries,” she added. 

“Moreover, the slope of the Phillips curve is likely to vary over time.”

However, arguments that rely on an ever-mutating relationship between variables that can only be determined in hindsight are problematic. 

They can quickly become an unfalsifiable way to assume that a relationship exists. 

If all this seems very confusing, the upshot is clear enough: Just like a hot economy didn’t prevent inflation from coming down, there is no guarantee that a cooler one will push it below 2%. 

The additional challenge for investors is that central banks will still act as if that is what it will do.