The Complicated Relationship Between Unemployment and Inflation

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One of the more complex data sets to analyze is unemployment data. It seems quite easy to understand on the surface, but it is often the data release that tends to perplex analysts most.

It’s not just that the market seems to go in the “wrong” direction to what you would expect, but also that the anticipated effects don’t appear to materialize.

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Inflation

The interplay between rising employment and inflation is not often understood because there isn’t as direct a connection as a lot of people might think. 

Generally speaking, higher employment means that more people have jobs, which would translate into higher demand, and using basic economics, this would lead one to conclude that prices will go up. 

However, more jobs usually mean that people are making more things, and this increased productivity can help offset that disparity between supply and demand – especially if there is a certain amount of elasticity in the market, for example from imports.

Let’s say that a particular country, Canada, doesn’t produce bananas. But demand for bananas in Canada goes up – does this mean the price of bananas will go up, and therefore inflation? Not necessarily.

Canada is a relatively small market in the world of banana production, so if they import some more bananas, the price remains stable because there is enough elasticity in production to account for it.

Multiply this effect across several products that have similar elasticity in supply, and the economy can easily “absorb” a certain amount of rising demand without causing a corresponding increase in inflation.

The Counterintuitive

In fact, speaking of a specific product, increased demand can actually push prices down. Like, for example, the bananas mentioned above. Since Canada is such a small market, it may not justify sending an entire shipload there, so they may be shipped first to the US, and then to Canada (we’re being super hypothetical here).

However, increasing demand makes economies of scale possible, and if there is enough demand for a shipload of bananas, now they can be shipped directly at a lower cost, instead of having to go through the US.

Going back to the part where people are hired to produce things, an efficient labor market hires people at wages lower than the value created with their work. What that means is that total productivity (supply) increases more than the total amount of wages (demand). 

This applies to jobs that are being created in productive sectors, such as manufacturing, certain services, agriculture, etc. Jobs that don’t increase value (generally government jobs, non-profits, and the like) will have the opposite effect.

Furthermore, this increase in productivity can return to cut prices through trade. Taking Canada as an example again, let’s say that oil companies are hiring more people because they are increasing production for export. 

Increased exports imply a higher demand for Canadian dollars as the export companies repatriate their profits, pushing up the value of the currency and making imported goods, such as the bananas, cheaper by comparison.

Nothing Is Isolated

Economic data releases can’t be interpreted in a vacuum since their meaning can be modified depending on other economic measurements. 

If unemployment is dropping, it could mean that there will be inflationary pressures – but if production as a consequence of new jobs being created outstrips the increased wages, then inflation might decrease. 

If unemployment is dropping, it also could be because fewer people are seeking jobs, which could also mean they have less disposable income, and that will lead to less inflation and a worse economy.

Knowing what the headline employment numbers are is undoubtedly useful, but just as important is understanding the reason behind them in order to have a firm grasp on what they mean for the economy, and eventually, for your trades.

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