Cut Unemployment Rate and You Risk Inflation

The emphasis on job creation by proponents of the recent federal highway bill introduced a theme that we will hear often as the election approaches. Voters will be watching the unemployment rate and expect the presidential candidates to present their views on how employment will be expanded. The danger is that campaign economics will tempt politicians into promises that risk a return to spiraling inflation in an effort to promote more jobs.

The decline in unemployment that began in 1982 is now complete. After falling steadily from its 10.5% peak in late 1982, the unemployment rate has stabilized at around 6.5%. From now on, any policy to reduce unemployment by stimulating the economy would cause rising inflation.

Economists agree that at any point there is a threshold unemployment rate below which unemployment cannot be pushed without raising the rate of inflation. Given the structural characteristics of the U.S. economy and our current labor force, that threshold rate is now in the 6% to 7% range.

In the 1960s and 1970s it was widely believed that it would be possible to have a permanently lower unemployment rate by accepting a permanently higher rate of inflation. But the experience of those years provides convincing evidence that trying to keep the unemployment rate below the inflation threshold level, even if only by a relatively small amount, leads to a continually rising rate of inflation. If the unemployment rate were now pushed down to, say, 5.5% by expansionary monetary and fiscal policy, we would see inflation rising from 4% in 1987 to perhaps 5% in 1988 and 6% in 1989. It wouldn’t take long to get back to double-digit inflation by such an attempt to maintain unemployment at a level below the inflation threshold rate.

Even without a policy shift to stimulate employment, the economy will experience higher inflation this year than in 1986 because import prices are rising and energy prices are no longer falling. Unless energy prices jump or the dollar drops faster than we expect, consumer prices should increase this year by about 4%, after having been nearly stable in 1986. Preventing this rise in inflation would have required a temporary slowdown in growth and a politically unacceptable rise in the unemployment rate between now and the election.

Looking further ahead, it should be possible to maintain this year’s combination of inflation and unemployment. And even with the unemployment rate remaining at about 6.5%, the number of jobs will increase as the economy grows. Although the unemployment rate is the same now as it was in 1977, the economy has added nearly 20 million jobs.

The inflation threshold rate of unemployment hasn’t always been as high as it is now. A few decades ago, it would have been possible to have an unemployment rate of 5% or 5.5% without raising the rate of inflation. But the increasing number of relatively inexperienced workers and the changes in the basic characteristics of the unemployed have pushed the inflation threshold level to the 6% to 7% range. Most of the unemployed are not traditional job losers looking for new work. More than two-thirds of them are new entrants to the labor force, those returning to work, individuals who quit their previous job, or workers on lay-off waiting to be recalled.

A presidential candidate who understands the current unemployment situation should emphasize to voters that future employment growth does not require lowering the unemployment rate, and warn them that trying to depress the unemployment rate by excess demand stimulus will only increase inflation.

The candidate might note that many of the long-term unemployed--about one out of seven have been without work for more than six months--are casualties of the trade deficit and many of them will be returning to work now that the trade deficit has begun to shrink. He should explain that groups with the highest unemployment rates--minority teen-agers and welfare recipients--might be helped by improved training options, but they would be particularly hurt by the proposed minimum-wage increase.

The Reagan Administration properly enjoys the credit for stopping the inflationary spiral. If it wants to ensure that this is a lasting legacy, Republicans in Congress and the Administration will have to avoid the temptation to try to create jobs by stimulating demand. Democratic hopefuls in Congress and on the campaign trail also must resist that temptation if they do not want to be faced with the same inflation problem that plagued the last Democrat in the White House.