You Decide: Has a Key Economic Rule Been Broken?

By Dr. Mike Walden

In many aspects of life there are rules we follow. These rules are usually based on experience, and they give us a general idea of what to expect.  The rules don’t always work, but they do give us some guidelines.

For example, one of my father’s rules was about education. As a high-school dropout and someone who worked outside in both the heat and the cold all his life, he was adamant that his children did well in school. So two of his rules were, first, come home from school and do your homework before anything else – including even dinner.  Second, get to bed by 9:00 p.m. and arise at 5:00 a.m. so his children could have breakfast with him before he left for work.

I followed my Dad’s rules and thank his memory almost every day for them.

When I went to college I found most fields of study, like economics, had their own rules.   However, these rules were different. They weren’t about personal behavior, but instead they were about how aspects of the discipline functioned. Importantly, the rules allowed users to make significant forecasts about how the economy operated.

I took my first economics course fifty years ago. One of the rules I learned in that course concerned the relationship between unemployment and inflation. The rule stated there was an inverse relationship between the unemployment rate and the inflation rate. This means that as the unemployment rate goes down the inflation rate rises, and vice-versa.

The rule is based on the idea that lower unemployment generates faster rising wages for workers.  Since labor is a key ingredient in making most products, if labor is more expensive, so too will be the cost of things we buy.

Of course, most of us would like to have a low-low situation, that is, both low unemployment and low inflation. So the rule is significant because it suggests an economy can’t have both – indeed, the economy has to pick one and endure the other.

The rule about unemployment and inflation has dominated the economics profession for decades.  It has also been a key factor for economic policymakers, particularly at the Federal Reserve (the “Fed”). This is because the Fed is mandated to watch both unemployment and inflation and use its influence to prevent either one from getting out of control.

The unemployment/inflation rule can go a long way in explaining the recent actions of the Fed.  During the years of the Great Recession (2007-2009) and immediately afterward, unemployment was high and inflation was virtually non-existent. Indeed, in 2009, average prices actually fell.   This situation allowed the Fed to focus on stimulating the economy and thereby lowering unemployment. The Fed did this by keeping interest rates low (in fact, at 0 percent) and pumping credit into banks.

Then by 2015, with the national unemployment cut in half to five percent and forecasted to go lower, the Fed began to raise interest rates in an effort to slow economic growth and contain inflation. By early this year, the Fed had raised its key interest rate from 0 percent to 2.4 percent.

But then a funny thing happened. Economists and others began to notice the inflation rate was not accelerating. Instead, it was staying in a range of between two percent and 2.5% (note – this measure includes average price changes for all consumer products and services).

One explanation is the Fed’s policy was working. Higher interest rates were slowing the economy and preventing the inflation rate from rising. There’s just one thing wrong with this reasoning however. The pace of economic growth actually accelerated between 2015 and 2019.

This turn of events has led some economists to question the traditional unemployment/inflation rule. If the rule is broken, the big question is, why?

There are two possible answers – automation and global trade. Automation in the workplace using machinery and technology is rapidly replacing workers in many industries. Look at manufacturing. Although there has been a slight rebound since the Great Recession, manufacturing employment is down 35 percent from its peak in the 1970s, even while manufacturing output is up 42 percent since just 1997. Automation means fewer workers are needed to make more output, thereby shrinking the impact higher wages would have on general inflation.

The same is the case for global trade. Buying more products from foreign countries allows US consumers to access bigger pools of labor, most of whom are paid lower wages than their US counterparts. So a tight US labor market can be avoided by companies using workers in other parts of the world.

If the unemployment/inflation rule no longer holds, there are both good and bad results. The good result is that we can finally have the best of both – low unemployment and low inflation – at the same time. The bad result is the end of the rule has largely occurred because there are now substitutes for US workers, in the form of automation and foreign trade.

You decide if this trade of the “good” for the “bad” has been worthwhile!

Walden is a William Neal Reynolds Distinguished Professor and Extension Economist in the Department of Agricultural and Resource Economics at North Carolina State University who teaches and writes on personal finance, economic outlook, and public policy.