The situation the United States currently enjoys—low unemployment, low inflation, and rapid growth—has left economists struggling for an explanation in light of its apparent incongruity with the tenets of two predominant economic theories of the past 40 years, the Phillips curve and the “natural rate of unemployment.” Although the theories differ, they both assume an inverse relationship between inflation and unemployment, and agree that to hold inflation in check, it is necessary to prevent unemployment from dropping too low, which in turn means restraining the pace of economic growth.

This issue of IRConcepts explains these two theories. It also explores structural changes in the economy that may help explain why the United States is enjoying both low unemployment and low inflation, and whether the current situation signals merely a pleasant interlude or permanent change.

For the past six-and-a-half years, the U.S. economy has been growing—at different rates at different times, but uninterruptedly. Corporate profits have soared, millions of new jobs have been created, and unemployment has plunged. The year 1997 was spectacular, what with an accelerated pace of growth, an unemployment rate that dropped to 4.6 percent in November, its lowest level in 30 years, and a falling inflation rate. In 1997, gross domestic product was up 3.8 percent (2.8 percent in 1996), unemployment was at 4.9 percent (5.4 percent in 1996), and the consumer price index—the main indicator of inflation—was up 2.3 percent (3 percent in 1996). (See Figure 1.) Despite the boom, the Federal Reserve, except for one small jump in interest rates, has allowed the economy to move forward.

Over the years, there have been some economists who have not seen inflation as a serious problem. Indeed, they claim that this overemphasis on achieving price stability has come at the cost of other national objectives. In their view, faster economic growth, even if it caused the inflation rate to rise, would enable the nation to raise living standards, add still more jobs, and, in general, better deal with other national problems. The late Harvard economist Sumner Slichter argued that a moderately rising price level is beneficial because it encourages businesses to invest in capital and increase production. His views are echoed by Nobel laureate James Tobin of Yale, who sees a little inflation as helping to “grease the wheels” of the economy.

Most economists are less sanguine about rising prices, particularly when the pace accelerates. They point to the following problems that come with higher inflation rates:

  • The major difficulty is that inflation complicates the process of making rational spending and investment decisions. In an effort to protect the value of their money, people tend to invest in more speculative ventures, and resources are channeled away from productive pursuits. Inflation also redistributes income within the population, because all incomes do not rise at the same rate.
  • While the income of some people rises faster than prices and they become better off, others fall behind and suffer a reduction in living standards. Generally, those with higher income are better able to protect themselves from inflation, but people on a fixed income, at any level, suffer.
  • On the international level, if the prices of U.S. products rise faster than those of other nations because of inflation, U.S. goods and services lose out in the global marketplace. Exports decline as consumers abroad cut their purchases of more costly U.S. products and, as the relative prices of imports drop, U.S. consumers substitute cheaper imports for domestically produced goods.

Concentrating on U.S. data for this century reveals that the worst periods of inflation have occurred in times of war (e.g., World War I, World War II, and Vietnam), when prices rose because there was too much demand relative to the supply of goods and services. Such “demand-pull” inflation has been due to the unwillingness of society to pay for the cost of war through higher taxes; it inevitably pays through higher prices.

While few economists would quarrel with this explanation of inflation as being related to periods of supply-demand imbalance, some would disagree that it accounts for rising prices at other times. Some economists diagnosed the situation as a new form of inflation, calling it “cost-push” inflation. In their view, prices rose because competitive forces could not overcome institutional barriers—e.g., unions and management negotiating big wage settlements, which were subsequently included in product prices—and not because of an excess of money chasing a shortage of goods.

Studying the course of wage changes in the United Kingdom from 1861 to 1957, A.W. Phillips of the London School of Economics discovered a correlation between the rate of change of money wages and the unemployment rate (a measure of how much slack there was in the labor market). His findings, published in 1958, are illustrated in Figure 2. The unemployment rate and the rate of change in money wages for each year are shown by a dot, and the resulting array of dots appears to form a pattern: When unemployment was high, wage increases were low, and when unemployment was low, wage increases were high. At the 1959 meeting of the American Economic Association, Nobel laureates Paul Samuelson and Robert Solow of MIT coined the term “Phillips curve” to describe this inflation-unemployment relationship.

Economists testing Phillips’s findings in other situations tended to confirm his hypothesis. Researchers then turned their attention to estimating equations that would determine money wages and prices. The prevailing opinion was that there was a clear trade-off between inflation and unemployment and that society could choose how much of each it was willing to tolerate.

Instead of society’s having that choice, some economists proposed that the freedom of unions and management to set wages and companies to set prices be curbed via “incomes policy”: something less than wage and price controls, but a general agreement to follow government guidelines. The aim of incomes policy was to shift the Phillips curve so that less unemployment could be achieved with a lower rate of wage increase. The basic idea was that if pay increases could be held down, then government could conduct an expansionary fiscal and monetary policy. Incomes policy blossomed in Europe and, with the Kennedy wage-price guideposts of 1962-1965, the United States had a version as well.

Many economists believed incomes policy caused a misallocation of resources and that when it did work, it was only for a limited period. In the United States, the whole discussion of the desirability of the wage-price guideposts died out in 1966 when the inflationary period ushered in by the escalation of the Vietnam War broke the back of the stabilization effort. (The nation, however, would try again under Presidents Nixon and Carter.)

The Phillips curve paradigm dominated economic theory for a decade. As is often the case, however, empirical results often did not conform to theory. When that happened, the Phillips curve advocates came up with variations on the theory to explain the discrepancies. This became harder to do as the discrepancies increased in size; the Phillips curve theory lost adherents in the 1970s when inflation and unemployment increased at the same time.

Among the economists who challenged the Phillips curve hypothesis were Nobel laureate Milton Friedman of the University of Chicago and Edmund S. Phelps of Columbia University, who offered a different hypothesis—the “natural rate of unemployment.” (The term was coined by Friedman in his 1968 American Economic Association presidential address.) Because of market friction, e.g., the time it takes to match an available worker with an available job, and structural change, there always will be some unemployment, even if the economy is in general equilibrium. At the equilibrium rate of unemployment—when demand and supply are in balance in the various markets—there is no tendency for prices to rise or fall. Therefore, the “natural” rate has become known as the Non-Accelerating Inflation Rate of Unemployment (NAIRU).

According to the natural rate hypothesis, the long-run Phillips curve is vertical and there is no permanent inflation-unemployment trade-off. Government policy designed to bring unemployment below its natural rate by creating additional demand will work only temporarily and, at the same time, generate inflation. As workers see rising prices eroding their real purchasing power, they demand higher wages. When their wages go up as much as prices, the incentive that led employers to add jobs is removed, and so unemployment returns to its initial level.

As can be seen in Figure 3, the economy starts from the equilibrium point X on the short-run Phillips curve P1, at which the natural rate of unemployment is OA. Then equilibrium is moved to point Y through the creation of additional demand; unemployment drops to OB, but the wage level will gradually rise from OC to OD. At the new wage level unemployment starts rising until it is again at its natural rate OA, at point Z on the short-run Phillips curve P2. The long-run Phillips curve is represented by the vertical line AE. Under these assumptions, the only way that lower unemployment could be sustained would be if the government continued to create excess demand.

Trying to keep unemployment below its natural rate requires a continuous boosting of aggregate demand, which in turn will lead to accelerating inflation. The policy implication is that society must choose either to adjust unemployment or to stabilize inflation, but it cannot do both. Starting in 1980, the choice became to stabilize inflation and, with fiscal policy no longer an option because of huge budget deficits, the task fell to monetary policy and the Federal Reserve.

The Federal Reserve, under the chairmanship of Paul Volker, took steps to end the inflationary spurt that had come with the second oil shortage crisis (1979). By slamming on the monetary brakes, the Fed successfully curbed inflation, but the policy also resulted in a deep recession. The ballooning of the federal deficit during the Reagan administration effectively ended discretionary fiscal policy in the United States, and the government has continued to rely on monetary policy to keep inflation in check. The Federal Reserve, assessing the nation’s supply of physical and human resources and its rate of productivity improvement, came to the conclusion that a noninflationary rate of growth in gross domestic product would be just over 2 percent. Therefore, if GDP started to accelerate beyond that rate, the Federal Reserve would tighten monetary policy. Indeed, the Fed’s raising of interest rates has been blamed for the 1992 economic slowdown.

As adherents of the Phillips curve had tried to determine the precise trade-off between inflation and unemployment, the devotees of the new theory sought to discover what the NAIRU actually was, even though Friedman had conceded that it was not fixed. In the early 1980s, estimates placed it at 7.25 percent, but events did not bear out the predictions; lower unemployment did not lead to accelerating inflation. So they started to lower their estimates of the NAIRU, attributing the reduction to structural changes in the economy. By the 1990s, the NAIRU was placed at 6 percent, and with it came the warning from these economists that any prolonged period of unemployment below that level would spell a new inflationary cycle. However, the unemployment rate dropped steadily, to its present 4.7 percent, without any consequent spurt in inflation.

Lower unemployment became possible because the Federal Reserve apparently no longer adhered to the natural rate hypothesis and did not jam on the monetary brakes as joblessness fell. If the events of the 1970s undid the Phillips curve approach, those of the 1990s have been equally unkind to the NAIRU view, leading to today’s uncertainty and the inability of the existing theories to explain the current situation.

A review of some changes in the U.S. economy may help shed some light on the current economic environment. Because some of these variables were not taken into account—indeed a few were considered impossible when the predominant economic theories were first devised—their effect was not calculated into economists’ formulas.

An assumption of the theories linking unemployment with inflation is that the supply of labor is limited in the short run. Thus, as economic growth accelerates, the pool of potential workers from which employers can draw dries up; to continue to attract workers, employers bid up the price of labor. The higher production costs then force companies to raise prices, and, unless the pace of growth is lowered, the inflationary cycle is under way.

Lately, however, the labor force has been growing 50 percent faster than the population, indicating that the labor supply is more elastic than previously assumed. As discussed in the last issue of IRConcepts, “The Changing American Labor Force,” the upsurge in female participation raised the total labor force participation rate more than 6 percentage points, from 60.2 to 66.6 percent, between 1971 and 1993. Since female participation is almost as high as that of males, the Bureau of Labor Statistics had expected it to increase much more slowly in the 1990s. However, in this period of economic ebullience, women have continued to pour into the labor market. Moreover, there are signs of reversal in the trend of male workers leaving the labor force at ever younger ages; older men have been jumping at job opportunities. Indeed, labor force participation is rising among all demographic groups.

Other factors also augment the supply of labor. The Americans with Disabilities Act has been accompanied by an increase in the number of employees who are disabled. Welfare reform is pushing people into the labor market. Immigration, legal and illegal, boosts the number of workers. In effect, employment can grow faster than had been assumed without causing labor shortages.

The supply of other resources has proven to be more elastic than traditionally assumed as well. Again, economic theory has held that the supply of physical capital is inelastic in the short run—during a boom one of the most closely watched pieces of information is the utilization of plant capacity. If aggregate demand exceeds the capacity to meet it, then prices simply are bid up and the traditional demand-pull inflation situation ensues.

New technology and economic globalization, however, have eased the supply shortage problem. Computerized processes often provide companies with the flexibility to shift their manufacturing processes from one product to another. Thus, when demand for a given product begins to outpace the demand for others, the company can reprogram its operations to meet that demand. The enhanced flexibility of the new technology thus helps to ease supply shortages.

Globalization is of still greater importance with respect to supply shortages. For U.S.-based multinational companies with plants throughout the world, capacity bottlenecks at U.S. plants may be overcome by shifting production to offshore facilities. This has been particularly true recently, when the U.S. economy has been growing at a healthy pace but those of other industrial regions—Japan and Europe—are expanding much more slowly and thus have excess capacity. Nonmultinational companies also can take advantage of foreign production capacity by importing intermediate products and components from abroad when their domestic suppliers run short.

Historically, most product markets were national, and for capital-intensive industries they tended to be oligopolistic, i.e., dominated by a few major producers. Under those conditions, when demand rose, one company in an industry would raise its price for a product and if it stuck, the others would quickly follow suit. With the spread of technology and the lowering of trade barriers—the heart of what we call economic globalization—many product markets have become international. This means that domestic producers, even when they encounter surging demand for their output, are constrained from raising prices lest foreign manufacturers undercut them and take away business. Thus worldwide competition has become the predominant factor in pricing.

Prices normally rise when firms encounter increased costs. A major source of higher production costs has been compensation. In a booming economy, when labor shortages develop, employers are forced to raise pay rates to attract workers. When collective bargaining was more common, unions also took advantage of tight labor markets to negotiate high wage and benefit settlements.

Unionized or not, workers today are cognizant of the increased domestic and foreign competition faced by their employers. They know that if their company’s labor costs increase because of high wage demands, the company may not be able to transfer those costs to customers. An employer will take some action to maintain its competitive position, such as relocating production to another plant. Even if the firm cannot shift production, a surge of lower-priced imports may undercut its sales. Fear of the resulting job loss restrains compensation increases, even in economically heady periods.

In the winter 1997 issue of the Journal of Economic Perspectives (JEP), Joseph Stieglitz, former chairman of the Council of Economic Advisers and now chief economist of the World Bank, offers another explanation of current employee behavior, which he calls the wage-aspiration effect. Workers’ wage aspirations are linked in a given period to the rate of productivity improvement, but they do not change quickly in response to changes in productivity. Thus, in the 1970s, when labor productivity improvement dropped perceptibly from its former rate of about 3 percent, workers still demanded high real-wage increases. Now, however, they have adjusted their real-wage aspirations down to reflect slower productivity growth.

Trying to understand today’s unemployment-inflation situation is complicated by the possibility that the data may be inaccurate, particularly those relating to productivity, that is, output per man-hour. Official BLS data show no improvement in productivity growth from the 1 percent rate of the past two decades. Moreover, there are internal discrepancies between sets of data, with national output as measured by income being higher than output as measured by goods and services (GDP). Economists were therefore dismayed when the revisions of GDP data for the past few years released in the summer of 1997 did not show greater output than originally reported, which would have indicated a higher rate of productivity growth.

Many economists, including Federal Reserve chairman Alan Greenspan, believe that the data relating to prices and productivity are no longer reliable. Industry’s heavy investment in capital equipment in the past decade or so is reflected in the higher productivity reported in manufacturing, but not in the data for the service sector, even though it too has been buying computerized processes. Any undercounting in the service sector, of course, affects overall productivity trends. Admittedly, it is difficult to measure productivity in services, but many are convinced that the gains are grossly underestimated. They point to low inflation in the service sector, which does not square with poor productivity growth. If output per employee is growing faster than reported, then firms are under less pressure to raise prices, a phenomenon that would contribute immensely to holding the line on inflation.

Part of the reason for the moderation of the inflation rate, despite tight labor markets, has been attributed to the decline of unions and collective bargaining. Unlike the situation in Europe, union wage pressure has not been accused of instigating inflationary bouts in the United States. In fact, the United States following World War II enjoyed a modest rate of inflation, except during periods of extreme conditions, such as war and the oil embargo and price hikes of the 1970s, which economists refer to as supply shocks. Once a supply shock occurred and triggered inflation, however, collective bargaining helped perpetuate it. For example, when the 1973 oil embargo and quadrupling of prices by the Organization of Petroleum Exporting Countries (OPEC) ignited inflation, unions demanded wage hikes for their millions of members on top of their contractual cost-of-living adjustments. As employers encountered higher labor costs they raised prices, and the all-too-familiar wage-price spiral was set in motion. Today, on the other hand, cost-of-living clauses have disappeared from most collective bargaining agreements and many fewer establishments are unionized. The decline of unionism has been a factor in moderating wage rises. Nonunion establishments do not face union wage demands, and organized ones are under less pressure because unions have lost bargaining power.

Even the need to raise the pay of some workers can currently be contained. In a boom period, the more skilled employees tend to be in short supply; to attract them employers offer higher compensation. Historically, those increases then would spread to the rest of the workforce. This was particularly true under collective bargaining, but even nonunion firms, in pursuit of internal wage equity, followed the practice. Furthermore, rising wages in one industry do not spill over to others, as they once did. We see the change today in the high-tech sectors of the economy, in which wages have been rising at above-average rates, but the pay boosts have not spread elsewhere, nor have they been translated into higher prices, since high tech also enjoys above-average productivity gains.

Some analysts dismiss the idea that the current situation is due to a fundamental change in the economy. Looking at the record, they attribute today’s low inflation to the absence of supply shocks suffered in prior periods, and to some temporary windfalls, such as a stronger dollar holding down prices of imports, lower oil prices, and subdued rises in health benefit costs. Those who claim that we have not achieved a new paradigm therefore warn that windfalls could quickly dissipate, that shocks could reappear, and that high inflation could return, despite globalization and union decline.

Returning to the economic theories relating unemployment and inflation, some economists contend that they are basically correct and that there just may be a time lag between the current low unemployment and higher inflation; as the old Brooklyn Dodger fans used to say, “Wait till next year.” Defenders of the Phillips curve claim that it is still valid, and that their models of the 1970s were off only because they did not take supply shocks into account. In fact, they report that their improved econometric models reveal a stable Phillips curve over the long run. The basic idea that there must be a relationship between labor market slack and wage rises is reasonable, yet unemployment has declined without a jump in inflation. Even with elasticity in the supply of labor, however, rapid economic growth will eventually produce severe enough shortages to force wages up; the point at which this happens, however, won’t be known until after the fact.

The current period also has wreaked havoc with the natural rate of unemployment hypothesis, since it has not be able to predict what that rate is. The assumption that the NAIRU was fixed at about 6 percent has been proven wrong, but that does not mean that the NAIRU does not exist. Common sense suggests that there is some level of employment at which a nation simply runs out of potential new entrants into the labor force. Indeed, during World War II, were it not for wage and price controls, wages and prices would have skyrocketed.

Accepting the fact that the NAIRU is not fixed and that changes in the economy have lowered it still leaves the problem of trying to determine at what actual level of unemployment inflation will set in. Economist James K. Galbraith of the University of Texas has termed the attempts to estimate the NAIRU “a professional embarrassment” for economics (JEP). Douglas Staiger and James H. Stock of Harvard and Mark W. Watson of Princeton state that “the natural rate probably lies between 4.3 and 7.3 percentage points of unemployment” (JEP). That band is wide enough to uphold Galbraith’s caustic comment, but, more importantly, it means that the NAIRU provides no guidance whatsoever to policymakers.

Economic theory has failed in another way—by focusing on unemployment as the sole predictor of future inflation, for there obviously are other and possibly better indicators, e.g., utilization of manufacturing capacity, index of new orders, and the federal funds rate, particularly for longer-run periods. The fact that two things are related, moreover, does not mean that one is necessarily the cause of the other and, in fact, they both may be the effects of a third factor. Looking at U.S. history of the past half century, it seems that shocks to the economic system have been the major culprit with respect to inflation, as demonstrated with the jumps in the price of oil in the 1970s.

Even the assumption of our entry into a period of a new economic paradigm does not mean that there can never be a problem of labor shortages causing higher wages and, consequently, higher prices. Adopting a commonsense approach to the issue of inflation and unemployment therefore starts with the understanding that there is some trade-off between them, as posited by the Phillips curve theorists. Similarly, when the supply of additional labor runs out, the curve becomes vertical, as claimed by the natural rate proponents. With that much knowledge, about all that can be concluded is that policymakers should be careful in attempting to push either unemployment or inflation down too far, lest it cause the other to rise inordinately. Indeed, this is precisely the policy that the U.S. government and Federal Reserve have been following, quite successfully.