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Can high employment coexist with low inflation?
The Federal Reserve certainly thinks so — indeed, it is basing its monetary policy on this very premise, according to Fed Chair Janet Yellen.
This may prove to be the case but if it does, it will only be for a moment in time. For you see, there normally is a trade-off between employment and inflation. If you want high employment, you have to be prepared for more inflation. On the other hand, if low inflation is your objective, it comes at the expense of less employment.
This is known as the Phillips Curve, a construct that describes an inverse relationship between inflation and unemployment. When inflation is high, unemployment is low and vice-versa.
That said, ours is not a static economy but a dynamic one, in which both inflation and unemployment move at different rates of speed, both in actual terms and in relation to one another, reflecting different degrees of slack.
For example, today's labor market is undeniably soft. Unemployment remains high, the long-term unemployment rate is the highest since the late 1940s, and many of those who are employed are working at jobs well below their skill levels.
At the same time, the measured rate of inflation is 1% or a tad below. This reflects weakness in the labor markets as well as in many commodities and finished goods, economy-wide. According to the Economist Magazine, commodity prices are running below a year ago, led by industrials, non-food agricultural products, and metals.
So if the economy were somehow made to grow faster, two things would happen: (1) the demand for basic commodities would rise and (2) the need for labor would increase, too. However, because the amount of slack in the labor and product markets is not the same not all prices would rise at the same pace.
At some point, the unemployment rate might descend to a level consistent with full employment. It is at this point that pressures on prices would begin bubbling up. It could take the form of a demand for higher pay, or higher prices at the checkout counter or both. That's when the trade-off will come into play and the Fed will have to decide which it prefers: low unemployment or low inflation.
Right now, the Fed is concentrating on boosting employment, since this appears to be the main concern of a majority of its members. They can have the luxury of worrying mainly about employment because, as noted above, inflation has all but disappeared.
That said, the Fed would actually like to see more inflation in order to reduce the burden of debt on households and companies. This would allow more borrowing. Spending would rise as well, since when prices rise, it makes business and consumers more eager to buy sooner.
In the Fed's ideal world, the economy runs a little inflation. In the real world, you can't have a little inflation any more than you can be a little pregnant.