Does full employment heat up inflation?

January 08, 1995|By Kim Clark | Kim Clark,Sun Staff Writer

Friday's report that the state and national unemployment rates had dropped to their lowest levels in more than four years might have escalated the inflation alarm among mainstream economists, but it didn't do much to convince people like Ed Meeks.

Mr. Meeks, who is in charge of hiring for Baltimore-based Senior Campus Living Inc., had been waiting since September -- when unemployment fell below its so-called "natural" level of about 6 percent -- for the tightening job market to create worker shortages and force wage boosts at the retirement centers he helps to manage.

After all, standard economic theory holds that when the nation reaches full employment, further hiring will push wages -- and inflation -- up.

Indeed, that has been one of the main premises that drove the Federal Reserve Board to raise interest rates six times in the past year in an attempt to slow growth and stave off a price spiral.

And Friday's report that the national unemployment rate slipped a fifth of a percentage point to 5.4 percent in December -- and Maryland's to 4.9 percent in November -- bolstered widespread expectations that the central bankers will raise rates yet again when they meet Jan. 31.

But now, despite three straight months of unemployment declines, area businesspeople and a few nationally known economists say that there is scant evidence of worker shortages or wage increases.

"I've been hearing that we are at the point where we can almost consider it full employment," said a skeptical Mr. Meeks, who is still getting swamped with applications for every position but nursing jobs.

"There are pockets" of shortages, he said, "But there are quite a few people who are overqualified for the positions" and willing to take pay cuts from their old jobs.

Mr. Meeks says he's not feeling any pressure to raise wages, and, even if he did, he might not pass it on in price increases to the residents of the nursing homes his company manages.

"There are too many variables to tie inflation to unemployment," he said.

But that's not what many economists believe.

The debate over the link between unemployment and inflation started in 1958, when British economist A.W. Phillips showed that wages in Great Britain increased during times of low unemployment.

On the belief that increased wages usually forced companies to raise their prices, economists soon included the "Phillips curve" in their models for economic predictions. In these, unemployment acts like one end of a seesaw: push down on unemployment, and inflation jumps up.

Later, American economists Edmund Phelps and Milton Friedman concluded that, when viewed over the long term, the economy tends to settle at a "natural" rate of unemployment. But pushing unemployment below that level sets off an inflationary wildfire that would spread throughout the economy, they said.

For most economists, the only debate since then has been over just what number the "natural" level is.

Robert Gordon, one of the nation's leading labor market economists, said U.S. economic history proves that the country is now on the verge of breaking the full-employment barrier, and may face a labor-shortage-induced inflationary spike.

"We know we had accelerating inflation in the 1960s" after unemployment dropped to about 4 percent during the Kennedy administration.

"And we know we had it in the late 1980s . . . when we had roughly the same economic conditions" appearing today, Mr. Gordon said.

Americans can expect an increase in inflation of about a half percentage point each year that the unemployment rate drops below the natural rate, he said.

But even Mr. Gordon can't explain why countries such as Japan, for example, have maintained very low unemployment and inflation rates for decades.

"This is one of the great dilemmas for the economic profession," he said. "Everything in Japan is crazy."

But a few economists wonder if one must assume that there is a trade-off between jobs and inflation.

Robert Eisner, of Northwestern University, is finishing an as-yet-unpublished study that, he says, shows there is little evidence that unemployment rates of 4 percent or 5 percent create accelerating inflation.

His study shows that low unemployment may tend to bump up prices but there is only a short-lived effect. Contrary to the standard economic theories, low unemployment doesn't set off a dangerous inflationary spiral, Mr. Eisner said.

"I have confirmed it using six different measures of inflation," he said.

Other economists are misinterpreting the evidence when they see signs of a trade-off, he believes. The inflation in the late 1960s, for example, wasn't caused by low unemployment but by the surge of spending on the Vietnam War, he said.

"I'm not indicating my economic estimates are the last word. But they raise a very serious question: Do we know what we are doing?"

He's presented the paper to some Federal Reserve bankers in an attempt to warn "You don't have evidence to support putting the economy through the wringer," he said.

Or do they?

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