How does inflation affect unemployment?

Business 23rd March 2022

The UK economy is currently experiencing inflation, the like of which anyone under the age of 40 will have no recollection. The energy crisis has pushed the annual inflation figure up to 5.5%, the highest it’s been since 1989 when it peaked at 8.5%. The question for HR is, what, if any, will be the impact of this surge on employment. After all, isn’t the country in the happy position of enjoying record low unemployment figures? The mid-1980s saw unemployment at an alarming peak of 12%. But now, it’s slumbering at a lowly pre-pandemic figure of 3.9%.

Does this mean that we can bask complacently in the sure knowledge that our employment ‘health’ is watertight – inflation-proof?. In this article, we’ll look at how continued relative high inflation might impact employment in the UK.
At first glance, it’s hard to find a direct causal connection between inflation and unemployment. However, there does seem to be evidence of an indirect link. Let’s look at one or two instances where this could be the case.

Inflation-led uncertainty and lower investment
Periods of high and volatile inflation can dissuade firms from investing. Firms are more likely to be nervous as to whether their investment will lead to higher profits. Lower investment leads to lower economic growth. In the long term, this scenario inevitably leads to higher unemployment.

Certain countries, such as Germany, manage to keep inflation levels permanently low. It was in 1989 that the German inflation rate last touched 5%. The resulting long periods of economic stability help to maintain a long-term low unemployment rate. This helps them to stay competitive, which in turn also keeps employment levels buoyant.

Inflationary booms cause recessions
The danger comes when an economy starts to ‘overheat’. In other words, the rate of economic growth is faster than the underlying sustainable rate of economic growth. Then the phenomenon known as demand-pull inflation (where demand starts to outstrip supply) tends to kick in. Firms push up prices because demand is growing faster than supply.

In the short term, this higher growth can lead to lower unemployment as firms take on more workers. It could be that this is what is happening in the UK now. However, this rate of economic growth is unsustainable – consumers may get into debt to increase spending, but as the economy falters, they cut back on spending, which leads to lower demand.

Furthermore, as inflation increases, the Bank of England is likely to increase interest rates to reduce inflation. This can cause economic growth to fall, leading to recession and unemployment. This is why an economic boom with high inflation is often followed by a recession and unemployment.

Can inflation be too low?
You might think that near-zero inflation can only be good for an economy. But, there’s a fine line between an inflation rate that’s too high and one that’s too low. With a very low inflation rate – say 1% – this is a sign that the economy is growing too slowly. This level of inflation means there is spare capacity and a resulting output gap. With slow growth, unemployment is likely to be higher. To rectify this scenario, governments need to pursue an expansionary monetary policy, where a higher inflation rate can help boost economic growth, bringing about lower unemployment.

A happy medium
It’s fair to say that the ‘golden scenario’ for overall economic well-being, including low unemployment, is a situation of extreme moderation – an apparent contradiction in terms. The challenge for national economies is to find a way of walking that ‘magic tightrope’ of modest-low inflation, sustainable growth and low interest rates. That way lies the best of all employment scenarios.

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