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Sunday, May 19, 2013

No inflation yet? Wait and see.....

For those disappointed about the continued absence of substantial US price inflation, it is beneficial to recap a little bit of Economics 101.

Below is one a classic piece of economic analysis, courtesy of It is called the Philips curve, after the economist who invented it. This particular chart is plotting the relationship between Unemployment and Inflation (a proxy for the latter is Rate of Change of Money Wage Rates), for the United Kingdom every year between 1913 - 1948.
File:Phillips curve.jpg
In short, the Philips curve states that high unemployment in an economy corresponds with low inflation, and vice versa. There has since Philips published his work been numerous refinements of the theory surrounding the Philips curve, however, there seem to be broad agreement on the key principles behind it.

Simply put: When general unemployment is above what economists define as the equilibrium unemployment rate, wage growth tends to slow, as the unemployed are competing for jobs. When unemployment is below, jobs are competing for the unemployed, bidding up wages. 

What the equilibrium unemployment rate is for an economy is dependent on a range of different factors. Unemployment benefits, minimum wages, laws that regulate hiring/firing, general ease/difficulty of doing business, quality of labor in a work-force etc, are general factors influencing supply and demand for labor. Generally, the more efficient/ the less restricted the labor market is, the lower is the equilibrium unemployment rate. Labor market rigidities explain why for example Spain was experiencing material wage inflation when it had 10% unemployment, while similar unemployment rates in the US on average led to declining wages.

Several analysts have estimated the US equilibrium unemployment rate to be north of 6%. This is up from its long term average between 4-5%, and reflects that long-term unemployment in the US have left more people less employable.

Currently, the US unemployment rate is 7.4%. This is still well above 6%. Hence, there is still higher supply of deplorable labor than there is demand, and on average no sign of inflationary pressure in wages.

As Uncle Ben Bernanke has promised us that he will keep printing money until US unemployment reaches 6%, he will not stop until he creates inflation. At the going speed of unemployed being hired, this point should be reached in about 12 months time.

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