What Does Low Unemployment mean for Inflation?

Will Lowest Unemployment in 40 Years Bring Higher Inflation?

October 16, 2018
Colin OSheaBy Colin O'Shea
Securities Analyst

The U.S. unemployment rate fell to 3.7 percent in September.  This is the lowest level since 1969, during the Vietnam War, and the lowest peacetime level since the U.S. started using the modern definition of unemployment in 1948. And the workforce might not have peaked yet — economists expect the unemployment rate to remain low for the next couple of years, perhaps even falling to 3.5 percent by 2020.

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The low unemployment rate is a response to the strength of the U.S. economy.  Households and companies remain confident, resulting in higher consumer spending and strong business investment.

are Unemployment and Inflation Related?

Typically, as the unemployment rate falls, businesses begin to struggle to find workers.  This leads to businesses having to increase wages to attract new employees from a smaller pool of applicants. This is good for workers, but a cause for concern with the Federal Reserve — because the longer the unemployment rate remains low, the higher the likelihood inflation will rise.   

To combat rising inflation, the Federal Reserve Open Market Committee (FOMC) usually raises short-term interest rates (like they did a few weeks ago). This, in turn, decreases the pace of consumer and business spending, thus slowing economic growth.

What does this mean for you? The increase in interest rates causes higher costs of borrowing for consumers and businesses, making it more expensive for you to get a home loan, car loan or apply for a credit card.

Is Low Unemployment Causing Inflation?

As of October 2018, inflation is currently running near the Federal Reserve’s long-term target. However, there are some signs of higher wages appearing in the current economic cycle. A recent National Federation of Independent Business small-business survey shows 37 percent of owners reported raising compensation for their workers. 

Why haven't we seen a sharper rise? The participation rate is one reason. The civilian labor force participation rate — the number of working age people actively employed or looking for work — declined during the financial crisis and remains at nearly a 40-year low. If the participation rate remains steady, we could see wages continue to increase. But if the participation rate increases and more people enter the workforce, wages (and therefore inflation) could remain rangebound.

Civilian Labor Force Participation Rate

The slower pace of inflation has allowed the FOMC to raise short-term interest rates at a slow, measured pace. The committee expects to continue to raising rates slowly with forecasts of one more interest rate hike in 2018 and three in 2019.

How Does Low Unemployment Affect Your Portfolio?

Some investments (real estate, certain commodities, stocks and inflation-indexed bonds) have been historically viewed as hedges against inflation. That being said, everyone's investment situation is unique. Contact a wealth advisor today, to learn how rising interest rates could affect your long-term financial plan.

About the Author

Colin O'Shea

Colin O'Shea is a Securities Analyst within the Wealth Management Division at Security National Bank, where he researches and analyzes assets and trade securities and helps develop investment strategies. A veteran who served in the U.S. Army for 12 years, O'Shea holds a Business Administration Degree from Morningside College.