August 8, 2017    5 minute read

Tight Labour Markets and Low Inflation: Possible Explanations

Outliers    August 8, 2017    5 minute read

Tight Labour Markets and Low Inflation: Possible Explanations

After years of economic slack, many central bankers in developed countries now think the time has come for them to tighten policy in order to avoid an overheating. This is because unemployment is at historic lows. In the US, for example, the latest reading of the unemployment rate came in at 4.3%, lower than the 4.7% that the FED estimates to be the ‘natural’ rate of unemployment. The situation is very similar in Japan and several other countries.


Still, inflation has stubbornly been below target and core inflation shows no signs of revival. This has prompted economists and policy makers to wonder whether the models they have always used have become useless (or they have always been wrong). This article, following the line of a recent FED’s Andolfatto blog post, provides some possible explanation as to why inflation has not picked up as expected. Before doing this, however, some clarity is needed on the framework in which central bankers typically address inflation.

Phillips Curve

In 1958 the economist A. W. Phillips finds a statistically significant negative relationship between inflation and unemployment in the UK. In itself, the relationship says nothing on the mechanism that generates it.

The theoretical model that followed, called the Phillips Curve Theory, explains inflation as a function of unemployment. The idea is very intuitive: when unemployment is low, the bargaining power of workers increases so that they are able to obtain higher wages; higher wages mean higher costs for firms, which will pass them onto consumers by raising prices.

The opposite is true when unemployment is high. Unemployment and wage growth are therefore fundamental determinants of inflation. Effects of wage growth on inflation can be offset by increases in productivity, which allows cost savings.

Incomplete Mechanism

It has to be clarified that the mechanism through which inflation is formed in this model is wrong, or at least incomplete, in the sense that wages and productivity are not the only determinants of inflation and unemployment is not the only determinant of wages.

For example, economists have long ago understood the central role that inflation expectations play on determining inflation. The negative relationship between unemployment and inflation is therefore not always observed. This is something economists have known at least since the 70s when both unemployment and inflation were running, a phenomenon successively called ‘stagflation‘.

Moreover, the (statistical) Phillips curve has been steadily flattening over the past decade, suggesting that the relationship between inflation and unemployment is weakening. Nevertheless, it is still today a reference point for central bankers to think of inflation.

Explanations Consistent With The Phillips Curve Theory

Of the several explanations proposed for the lack of inflation despite tight labour markets, one consistent with the Phillips Curve goes as follows: despite unemployment has completely recovered from the financial crisis, other measures of unemployment, such as the U-6 unemployment, which measures those working part-time but wishing to switch to full-time, have not. The U-6 unemployment rate is currently at 8.6% in the US. The labour market is not really tight – this is the wrong metric – as those workers represent labour offer on the market. This is what explains the lack of wage growth and thus inflation.

Another explanation which is completely consistent with the main idea of the Phillips Curve has to do with technology. Technological progress has increasingly allowed for substitution of workers with machines in the production process. This possibility has given a great power to employers, who have no incentive to raise wages even in tight labour markets. This reasoning clearly denies the negative relationship between unemployment and inflation, but it is still consistent with the Phillips Curve in the sense that the mechanism of inflation formation is the same: inflation increases when wages increase. What’s missing now is wage growth, as workers’ bargaining power has not increased.

Other Explanations

Several alternative theories of inflation have been proposed and some of those can offer suggestions on further possible explanations for the lack of inflation. One theory models inflation as only determined by inflation expectations. This model views inflation as a self-fulfilling process: if firms think prices will be low, they will set low prices and pay low wages to their workers.

Note that this model contradicts the Phillips Curve Theory: expectations on prices determine prices, which in turn determine wages, not the other way around. This theory suggests the first alternative explanation: if there’s been deflation for over a decade, then it is no surprise that firms expect more deflation to come. This reasoning is interesting, but it certainly neglects any role policy makers can have in driving expectations.

The second explanation is even more interesting, as it acknowledges that nowadays firms operate in an open and global environment. Wages are not the only cost that firms face, but they also face the cost of importing production factors from abroad. The second alternative explanation states that the lack of inflation in the developed world is due to developing countries.

This is for two concurrent reasons. Firstly, because emerging market economies typically have lower costs of labour, outsourcing allows developing countries firms to obtain significant cost savings, by actually outsourcing or simply by increasing firms bargaining power over local workers. Secondly, the competition of cheap products from abroad prevents firms from significantly raising prices.


It should now be clear that the mechanism of formation of price pressure is much more complicated than what suggested by the Phillips Curve. Today it is not enough to say that labour markets are tight to argue that inflation (and thus interest rates) will increase.

The confidence on the future path of interest rates that the FED has recently tried to convey to financial markets seems a bit misplaced. In my opinion, this casts doubt on the appropriateness of the third rate raise this year. The FED should consider stepping back to gather more information on the actual price pressures in the US economy. Considering how used markets are to the FED underdelivering, this should not cause too an abrupt reaction.

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