Will a falling unemployment rate keep U.S. inflation above target?

Over the past year, the U.S. labour force has contracted as unauthorised immigrants departed and the labour force participation rate declined. A recent note from BCA Research considers whether a falling unemployment rate will keep U.S. inflation above target.

The firm observes that the contraction in the U.S. labour force means the threshold for job growth to reduce the unemployment rate has been lowered. Investors are now asking if the labour market will tighten enough to keep inflation above the Fed’s target even if tariff and energy effects fade over the coming year.

Jonathan LaBerge of BCA Research notes that the Phillips Curve’s picture of the relationship between the unemployment rate and inflation is conflicting. He points out that from both 1999 to 2000 and from 2018 and 2019, there was a below 4% unemployment rate without high inflation. But there was much higher inflation along with low unemployment rates in the late 1960s and in the 2022 to 2024 period.

The Phillips Curve describes the relationship between inflation and unemployment over the short term, and is typically interpreted as showing that when demand is strong and unemployment low, there is inflationary pressure; weaker demand and higher unemployment, by contrast, reduce inflation.

The firm believes a below 4% unemployment rate might prove inflationary this time, given that the combination of low unemployment with low inflation seen in the 1990s was due to productivity gains. While AI might increase productivity at some point soon, no such gains are visible in the productivity data. Furthermore, from 2018-2019, inflation expectations were much lower, and that probably restrained wage growth.

“Our US Investment strategists see fears of a significant wage growth breakout as overdone. Entrenched misperceptions die hard, but the structural balance of power between workers and employers has shifted too far to permit a repeat of the 1970s,” LaBerge said.

He noted that the post-pandemic wage growth surge was due to a labour supply shortfall. At that time, the quit rate was at record levels, indicating there was poaching between firms, generous fiscal transfers had slowed down labour’s return to work, and employers attempting to fill openings had to bid up wages. These conditions no longer prevail.

The firm argues that the negligible cost of posting roles online has led to overstatement of current openings. It says the depressed hiring rate now shows that labour demand has subsided while the labour supply is squeezed due to immigration enforcement.

BCA Research believes that structural forces are in the favour of employers, while workers have less leverage against shareholder-focussed management as private-sector union membership has collapsed. The firm does not think that the forces responsible for causing a wage-price spiral are in action, and says worries about such a scenario are based on memories of exceptional labour policy actions that are very unlikely.

While a self-reinforcing loop of wages and prices driving each other higher is off the table, it remains a possibility that the Fed will deliver a hawkish surprise over the next 12 months, the firm added.