A Lower Unemployment Rate, Inflationary Pressures, and Central Banks in Policy

How low can the unemployment rate go without causing excessive inflation? It’d be a nice experiment to find out. Usually not mentioned is that big banks – which of course wield pretty significant power – dislike inflation because they’ll typically have a supply of long-term loans on their books. Those loans stand to depreciate in value with higher inflation, and that’s largely the reason why there’s such pressure to keep inflation lower than necessary through central bank interest rate increases.

The loans of banks and other financial corporations typically are set at a fixed rate, so again, the repayments of those loans will be worth less to them if inflation rises. For one example, if a bank offered a 5 percent home loan while expecting that inflation would be 1 percent, the bank would assume that it would receive a real interest rate of 4 percent. If the inflation rate actually becomes 2 percent, the bank will take a considerable profit loss (receiving a 3 percent real interest rate) compared to what it expected, as there’s less loan money for it in real terms because of the higher inflation.

The interest rate increases do of course have the side effect of slowing the economy, and that contributes to a higher unemployment rate that leaves lower-income employees less bargaining power for wage increases. Along with how interest rate raises (beyond a certain point, of course) lead to less job opportunities, the point about worker bargaining potential is important, as a central bank wields a lot of power in society. It’s preferable to see that power used for the common good instead of for the financial conglomerates that have caused too many problems already.

Just four years ago the Congressional Budget Office put the floor of the unemployment rate at 5.5 percent. This estimate implied that if the unemployment rate fell below this level that the inflation rate would begin to spiral upwards.

The unemployment rate has now been well below this level for more than two-and-a-half years, and there is still no evidence of an inflationary spiral. In fact, the inflation rate remains well below the Federal Reserve’s 2 percent target.

If the Fed and Congress had tried to craft monetary and fiscal policy around this 5.5 percent figure, as many economists advocated, millions of workers would have been needlessly denied the opportunity to get jobs. Tens of millions would be looking at lower wages, as the tighter labor market has finally allowing workers at the middle- and bottom-end of the labor market to finally share in the gains of economic growth.