The Biggest Question Mark About Global Inflation and Unemployment

Typically, interest rate hikes are supposed to lead to lower inflation and higher unemployment, especially when those hikes are enacted as vigorously as they were in the second half of 2022. 

Here’s why: As borrowing money and the corresponding opportunity cost becomes more expensive, fewer consumers take out loans for new homes or cars. Businesses can’t access opportunity-appropriate financing to make new investments. These downward pressures on asset investment all translate to a lack of demand that ripples outward. Inflation drops, unemployment grows. The economy stabilizes with employment coming back slowly without inflation.

But this isn’t occurring yet in this cycle, even as inflation began to level off in late 2022.

• The US unemployment rate hit a 53-year low of 3.4% in January, with more than 517,000 jobs added. There have been a series of high-profile layoffs at Meta, Amazon, Microsoft and other large tech companies, but the size of those cuts has been relatively small compared to the overall US economy. 

• UK unemployment was 3.7% in the fourth quarter of 2022, though the number of job openings declined.

• The European Union reported 6.1% unemployment in December, an all-time low, and the European Commission now forecasts that it will avoid recession.

• Canada had 5% unemployment at the end of January, slightly higher than its record low.  

• Australia, however, saw a slight uptick in unemployment from 3.5% to 3.7% in January.

• India’s unemployment rate rose to 7.45% in February, up from 7.14% in January, but still lower than the fourth quarter of 2022.

The news has alarmed investors, who believe it could lead the US Federal Reserve and other central banks to raise interest rates more aggressively in the coming months. 

It raises a big question for this environment: Does unemployment have to increase for inflation to continue shrinking? 

How the Phillips curve does (and doesn’t) explain what is happening with inflation and unemployment

The Phillips curve is the concept that says inflation and unemployment have an inverse relationship. When one goes up, the other declines.

Technically, the original version of economist William Phillips’ theory was on the connection between unemployment and wages. Other economists extended the link from unemployment to inflation. 

There have been cases where the economy defies the Phillips curve, like times of stagflation (high inflation, high unemployment) or the period just before the pandemic (low inflation, low unemployment). Some economists argue the curve is only accurate over the short term.

While there are criticisms of the theory, it’s still a popularly used tool and often influences central bankers’ thinking. That’s why it doesn’t make sense to completely dismiss the curve. Higher unemployment may still be on the way. 

“My sense is that we’re dealing with a lagging indicator,” said Chris Atkins, C2FO’s president of capital finance and capital markets.

It can take several months before central bank rate increases translate into real-world effects. The US Federal Reserve made the first of last year’s hikes in March, and the larger increases of 75 basis points per Fed meeting didn’t start until a few months later. 

As we get deeper into 2023, Atkins said, we could start seeing more impacts from those rate increases.  

“The next six months is really going to tell us what we’re dealing with here,” he said. 

Other influences on inflation and unemployment

While unemployment has remained low, wage growth has tapered off over the last several months in several markets, which could be helping to contain inflation.

In the US, wages increased by 1% in the last quarter of 2022, compared to 1.3% and 1.4% in the previous two quarters. That’s much closer to what’s considered normal: In 2018 and 2019, the average quarterly increase was about 0.75%, the World Economic Forum reported.

It should also be acknowledged: This isn’t a totally normal labor market or inflation cycle. In some regions, there are significantly fewer workers today than before the global pandemic. 

The UK has about 600,000 fewer employees compared to early 2020, which is raising fears about productivity and economic growth. In the US, there are roughly 3 million fewer people in the workforce, even as US employers created 4.5 million jobs in 2022, the US Chamber of Commerce reported. 

Some of the missing workers have retired or started new businesses. Many are in caregiving roles or dealing with their own ailments and disabilities. Others have died.

Whatever the root cause, the smaller supply of workers isn’t lost on employers, which have spent the last few years fighting for new hires. They recognize that competition for workers is going to be fierce for the foreseeable future. 

That’s why it could be a better strategy for many businesses to avoid laying off workers, especially if a potential recession or downturn is relatively short and mild. After all, consumers have been remarkably resilient and continued to spend. 

When things pick back up, replacing those employees could be difficult, throttling their company’s growth. That’s one reason why unemployment might still be low. 

The bottom line about inflation and unemployment

When it’s hard to see exactly where things are headed, smart business operators do everything they can to preserve their optionality. Specifically around finances, they make sure they have access to capital in case they need to quickly invest in opportunities.

When it comes to staffing, extra cash on hand can give smaller businesses the resources they need to retain workers during a possible downturn, instead of firing them and then — a few months later, after things have improved — trying to hire replacements in what promises to be a very tight job market. 

C2FO’s early payment solution can be particularly helpful for increasing working capital in an environment like the current one, where inflation is still high and interest rates keep rising. 

Using C2FO’s platform, companies can boost their cash flow by requesting early payment in exchange for a small discount on their invoices. It’s a less expensive and less cumbersome option than seeking a term loan or line of credit from a traditional lender. Click here to learn more.