Economists have been arguing about the connection between unemployment and infl ation for decades. Critics claim that the connection is unreliable and leads policymakers astray, while others argue that the relationship is useful for forecasting. We examine the more direct connections between elevated unemployment levels and the rate of increase in wage and labor costs, more generally. We fi nd that wage and labor cost growth has declined markedly following recent recessions. It has again declined sharply in the most recent recession. We also fi nd that compensation typically remains subdued during the initial phases of recent recoveries. This is again the case in the current recovery, making labor costs a significant restraining force on inflation going forward.Recessions ; Inflation (Finance) ; Inflation targeting

Kyle Fee

Mark E. Schweitzer

English

Research Papers in Economics

ECONOMIC COMMENTARY
Number 2011-17
September 7, 2011
Unemployment, Labor Costs, and Recessions:
Implications for the Inﬂ  ation Outlook 
Kyle Fee and Mark E. Schweitzer
Economists have been arguing about the connection between unemployment and inﬂ  ation for decades. Critics claim 
that the connection is unreliable and leads policymakers astray, while others argue that the relationship is useful for fore-
casting. We examine the more direct connections between elevated unemployment levels and the rate of increase in 
wage and labor costs, more generally. We ﬁ  nd that wage and labor cost growth has declined markedly following recent 
recessions. It has again declined sharply in the most recent recession. We also ﬁ  nd that compensation typically remains 
subdued during the initial phases of recent recoveries. This is again the case in the current recovery, making labor costs 
a signiﬁ  cant restraining force on inﬂ  ation going forward.
  ISSN 0428-1276
It is logical to assume that today’s unemployment rate is high 
enough to inﬂ  uence the compensation of workers who ﬁ  nd 
themselves competing with millions of other unemployed 
people for the same jobs. This connection between real 
economic activity and prices is what economists refer to as a 
“Phillips curve,” which, despite how reasonable the relation-
ship seems, has been extensively criticized as unreliable. 
One criticism concerns the use of the Phillips curve relation-
ship as a basis for monetary policy, since the curve could 
suggest that a tradeoff between inﬂ  ation and unemploy-
ment exists. The existence of such a tradeoff could mean 
that causing an increase in inﬂ  ation will lower unemploy-
ment. Two notable critics of that idea, Nobel prizewinners 
Edmund Phelps and Milton Friedman, ﬁ  rst argued in the 
late 1960s that any tradeoff between inﬂ  ation and unem-
ployment would exist only in the short run; once the public 
expected higher inﬂ  ation in the future, the effect would dis-
appear. Thus, expansionary monetary policy leads to more 
inﬂ  ation rather than a decline in the unemployment rate. 
This critique aptly describes the Fed’s policy errors during 
the 1970s, which many critics of current monetary policy 
fear are being repeated. 
More technical limitations to the Phillips curve have also 
been noted. In particular, the forecasting performance of 
various forms of the Phillips curve has been shown to be 
unreliable in certain time periods. In the extreme, econo-
mists have argued that in recent time periods “. . . Phillips 
curves are not useful for forecasting inﬂ  ation.” This is not 
a mainstream conclusion particularly among economic 
forecasters, but the instability of the relationship is widely 
recognized and is a real challenge for central banks.
Conversely, a recent paper by James Stock and Mark Wat-
son argues pretty convincingly that “U.S. recessions are as-
sociated with declines in inﬂ  ation.” In their work, Stock and 
Watson use a time-scaling technique to compare increases 
in unemployment and declines in inﬂ  ation over business 
cycles. Using the time scaling technique, they are able to 
compare similar points in time during business cycles of 
various lengths. Their results point to a more stable relation-
ship between the rise of unemployment in recessions and 
lower subsequent trend rates of inﬂ  ation. 
In order to focus a little deeper on the underlying response 
of labor costs to unemployment, we explore the connec-
tion between elevated unemployment levels and the rate of 
increase in labor costs, using Stock and Watson’s technique. 
We conclude that labor cost growth has already declined 
markedly, and labor costs are likely to be a signiﬁ  cant re-
straining force on inﬂ  ation going forward. Furthermore, the 
patterns of past recessions indicate that most of the decline 
in labor cost growth may have been already realized. 
Ultimately, we will have to look back on the next couple of 
years of data to see how inﬂ  uential elevated unemployment 
rates were on the inﬂ  ation process, but in the meantime, 
economic projections for inﬂ  ation have to be guided by 
something. At the very least, projections must assume an 
implicit view on the question of what effect unemployment 
has on compensation growth and inﬂ  ation.
2011-17.indd   3 9/7/2011   11:29:25 AMFigure 1. Employment Cost Index
Note: Shaded bars indication recessions.
Source: Bureau of Labor Statistics.
0
2
4
6
8
10
12
14
16
1980 1984 1988 1992 1996 2000 2004 2008
Four-quarter growth rate
Beneﬁts
Compensation
Wages and salaries
Recent Compensation Trends 
In this analysis, we primarily use the employment cost 
index or ECI to measure growth trends in labor costs. The 
ECI comprises two series: wages and salaries, and beneﬁ  ts. 
Wages and salaries includes all types of salaried and hourly 
wage rates, but we will refer to the series as wage growth 
for brevity’s sake. Wages and salaries typically contain 
the clearest information about ﬁ  rms’ pricing decisions, as 
changes in beneﬁ  ts can often be out of a ﬁ  rm’s control. But 
since beneﬁ  ts make up about 30 percent of total compensa-
tion (according to the Bureau of Labor Statistics’ Employer 
Costs for Employee Compensation), we do include them in 
our analysis. Note that the type of beneﬁ  ts included in the 
ECI go beyond your traditional health insurance coverage. 
Overtime pay, vacation days, sick time, pension and other 
retirement plans, and social security and unemployment in-
surance are all accounted for under the ECI’s beneﬁ  ts series. 
One key factor in choosing to use the ECI data as the 
source of wages or compensation data is that it is structured 
as a price index, with a ﬁ  xed set of occupations designed 
to be representative of the typical U.S. workforce. This 
prevents distortions in the data that might occur during re-
cessions as certain employment groups decline. It also helps 
to avoid the cyclical variability that other pay measures are 
exposed to. 
The ECI data do not go back very far, so results should be 
interpreted with caution. To check the sensitivity of our re-
sults to the limited sample period, we redo the analysis with 
various other measures of employment costs (compensa-
tion per hour, average weekly wages).These measures have 
longer histories but produce similar results. 
Even though the ECI total compensation series only began 
to be reported in the early 1980s, it clearly shows that 
compensation growth has tended to decline during and 
after recessions (ﬁ  gure 1). It also shows that compensation 
growth is not recovering like it used to: It has not returned 
to its prerecession level in any of the recent business cycles. 
This is despite the fact that beneﬁ  ts costs have at times 
increased rapidly.
Compensation growth has slowed 2.5 percentage points 
from its peak in 1990. The latest ﬁ  gures put growth at only 
2.5 percent over the past four quarters. The decline reﬂ  ects 
both wage and beneﬁ  t reductions, although in this case, 
beneﬁ  ts growth fell more sharply, going from 6.5 percent 
to 1.9 percent. During the 2001 business cycle, compensa-
tion growth slowed by 1.9 percentage points, even though 
strong growth in some beneﬁ  ts such as health insurance 
supported total compensation growth over the period. The 
2007 recession shows a similar pattern, although given what 
we can tell from past business cycles, the full extent of the 
slowdown may not yet be known.
Compensation Growth during and after Recessions
To clarify the relationship between recessions, unemploy-
ment, and compensation growth, we modify Stock and Wat-
son’s time-scaling approach and apply it to the ECI data.1 
Figure 2 shows wage growth and unemployment data scaled 
for comparison using this approach. While there are only 
three complete business cycles, a pattern is evident. Wage 
growth declines during recessions as the unemployment 
rate increases. Wage growth then stabilizes at lower levels 
following the peak in the unemployment rate. In the case of 
the 1990 recession, wage growth remained 1.5 percentage 
points lower than it had been at the previous business cycle 
peak until 1995. Following the 2001 recession and the job-
less recovery, wage growth dropped 1.5 percentage points in 
2005 and remained 0.5 percentage points lower all the way 
to the start of the 2007 recession. 
Post-recession declines in unemployment do not seem to 
have an analogous effect on wage growth. Rather, wage 
growth appears to remain stable even as unemployment de-
clines. This suggests that increases in unemployment cause a 
one-time adjustment in wage growth rather than there being 
a tight ongoing relationship between unemployment and 
wage growth during and after recessions. 
Currently, wage growth is running in line with the two prior 
cycles’ patterns at about 1.6 percentage points lower than it 
was before the recession. In one sense, the limited decline 
in wage growth is surprising given that the increase in the 
unemployment rate is far larger in this recession. A simple 
regression model would support the view that the declines 
in wage growth are far less than expected given the size of 
that increase in unemployment. A regression model would 
also tend to anticipate increases in wages going forward 
2011-17.indd   4 9/7/2011   11:29:25 AMFigure 2. ECI: Wages and Salaries and Unemployment 
Rates
Figure 3. ECI: Compensation and Unemployment Rates
Source: Bureau of Labor Statistics. Source: Bureau of Labor Statistics.
–8.0
–6.0
–4.0
–2.0
0.0
2.0
4.0
6.0
0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0 5.5 6.0
Unemployment peak
Percentage point change from the business-cycle peak
Unemployment
ECI
1982
1990
2001
2007
–8.0
–6.0
–4.0
–2.0
0.0
2.0
4.0
6.0
0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0 5.5 6.0
Unemployment peak
Percentage point change from the business-cycle peak
Unemployment
ECI
1982
1990
2001
2007
rather than the relatively level pattern seen in the ECI in 
past recoveries. Of course, such an analysis would also point 
to the limited statistical reliability of the estimates due to the 
very small number of observations. 
Compensation growth is a better overall measure of labor 
costs than wage growth, because producers have to set their 
prices to cover both wage and beneﬁ  ts costs. Yet beneﬁ  ts 
costs are more variable than wage and salary payments (see 
ﬁ  gure 1). Indeed, anecdotal reports from business contacts 
suggest that beneﬁ  ts costs are subject to surprises that can 
make them harder to contain. Still, over time, employers 
also report adjusting either wages or beneﬁ  t-program costs 
in order to hit a given labor cost target. 
Applying the Stock and Watson approach to compensa-
tion data reveals a pattern similar to wage growth (ﬁ  gure 
3). Compensation growth declines in recessions as the 
unemployment rate increases, then stabilizes at lower levels 
following the peak in the unemployment rate. In the case of 
the 1990 recession, compensation growth remained roughly 
2.2 percentage points lower until 1999. Following the 2001 
recession and the jobless recovery, compensation growth 
remained about 1.5 percentage points lower all the way to 
the start of the 2007 recession. Currently, compensation 
growth is running between the two prior cycles’ patterns at 
0.9 percentage points lower than it was before the recession. 
Again, conventional regression methods would indicate 
that the current declines in compensation are far less than 
expected given the increases in unemployment. 
Applying the Stock and Watson procedure to one of the 
data series with a longer history yields similar conclusions. 
Averaged over the 10 post-World War II business cycles, 
compensation per hour decreased as unemployment signiﬁ  -
cantly increased. A period of declining unemployment yet 
stagnant compensation growth followed (ﬁ  gure 4). 
While detailed results on total compensation are inherently 
limited by data availability, our analysis of recent business 
cycles reveals three simple observations:
￿  The increase in unemployment associated with the past 
three recessions has in each case signiﬁ  cantly dampened 
compensation growth
￿  Elevated unemployment rates past the peak of the 
unemployment rate have not tended to lower compensa-
tion growth further
￿  Declines in unemployment rates following the peak in 
unemployment have not resulted in an immediate ac-
celeration in compensation growth
While this pattern is very consistent with Stock and Wat-
son’s results for a lower inﬂ  ation trend following recessions, 
this pattern is not fully consistent with the most basic Phil-
lips curve. The breakdown lies in the period following the 
peak in unemployment. The theory states that as the unem-
ployment rate declines, labor costs should increase. In our 
analysis, we ﬁ  nd that labor costs remain subdued following 
the peak in unemployment. 
Subdued Compensation Growth and 
the Inﬂ  ation Outlook 
Intuitively, it makes sense that subdued labor costs should 
act as a restraint on future inﬂ  ation for a number of reasons. 
Labor compensation is the main input cost companies must 
consider when setting prices. Labor costs are a substantial 
2011-17.indd   5 9/7/2011   11:29:25 AMFigure 4. Compensation per Hour and Unemployment 
Rates
Source: Bureau of Labor Statistics.
–4.0
–2.0
0.0
2.0
4.0
6.0
0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0
Unemployment peak
Average of 10 postwar cycles
Unemployment
2007 cycle
Percentage point change from the business-cycle peak
Standard error 
of the mean
Compensation 
per hour 
share of the total cost of producing and providing ser-
vices—for example, legal services, medical care, or barber 
shops—and other services now make up a much larger share 
of our economy. Notably, they represent about 60 percent 
of consumer purchases in the CPI basket. Inﬂ  ation in the 
service components of the CPI has in fact been highly 
correlated (0.72) with compensation growth since the early 
1980s. Even though none of these results offers evidence of 
which way the causation might run, they are consistent with 
a period of restrained price changes in many parts of the 
consumer market basket.
To add more of a causal interpretation requires an economic 
model of the price setters’ decision process, which links 
wage and price setting in a manner consistent with rational 
inﬂ  ation expectations. The literature on “New-Keynesian 
Phillips curves” provides such a framework and addresses 
many of the early critiques of Phillips curves. For example, 
Jordi Gali, Mark Gertler, and Argia Sbordone have devel-
oped models where ﬁ  rms set their product prices infrequent-
ly based on their costs. This implies a tight link between 
labor costs and inﬂ  ation, as forward-looking pricing rules 
respond to cover current and future labor costs. 
These models also stress the importance of accounting for 
productivity growth by considering the cost of a representa-
tive unit of output or unit labor costs. We have ignored unit 
labor costs to this point in the Commentary because volatility 
in productivity growth across the business cycle tends to hide 
the compensation growth patterns. Still, for compensation 
growth to put upward pressure on inﬂ  ation, it needs to exceed 
productivity growth and the current rate of inﬂ  ation. Today 
that is not the case. With compensation growth at 2.3 percent, 
it is near the trend rate of productivity growth of about 2.0 
percent and well below the sum of productivity growth and 
inﬂ  ation. This implies that the labor market is applying no 
pressure on the pricing of domestic producers. 
This lack of labor cost pressures is also being currently 
conﬁ  rmed by many businesses. In anecdotal surveys con-
ducted by the Federal Reserve Bank of Cleveland for the 
Beige Book, contacts have frequently reported that subdued 
compensation growth has been a critical factor behind 
limited product price increases even while commodity prices 
accelerated in the spring of 2011. 
While our analysis did not clarify how long subdued com-
pensation growth might be expected to continue, forecasters 
and policymakers should continue to be watchful for signs 
of acceleration. However, recent indicators point to minimal 
expectations of wage increases over the next year. Moreover, 
evidence from recent business cycles argues that compensa-
tion growth has been and is likely to remain rather subdued 
until the recovery has progressed much further, which is 
helping to dampen cost pressures for both domestic goods 
and service producers. 
An inﬂ  ation scare driven by other factors, like consumer 
inﬂ  ation expectations or commodity price increases, can-
not be ruled out even with high unemployment rates. 
However, for that inﬂ  ation to be sustained like it was in 
the 1970s, we would need to see a sharp turnaround in 
compensation growth. 
Footnote
1. The time dimension of each data series has been rescaled 
so 0 is the start of the recession (as declared by the National 
Bureau of Economic Research or NBER), while 1.0 occurs 
at the peak of the unemployment rate. Figures 1–4 plot 
percentage point changes in the unemployment rate and 
wage and compensation growth from the NBER-designated 
business-cycle peak, which helps to account for the previous 
trend in the data.
2011-17.indd   6 9/7/2011   11:29:26 AMRecommended Reading
“Are Phillips Curves Useful for Forecasting Inﬂ  ation?” by 
Andrew Atkeson and Lee E. Ohanian, 2001. Federal Re-
serve Bank of Minneapolis, Quarterly Review, vol. 25, no. 1.
“The Role of Monetary Policy” by Milton Friedman, 1968. 
American Economic Review, vol. 58.
“Inﬂ  ation Dynamics: A Structural Econometric Analysis,” 
by Jordi Gali and Mark Gertler. 1999. Journal of Monetary 
Economics, vol. 44.
“Modeling Inﬂ  ation after the Crisis,” by James Stock and 
Mark W. Watson, 2011. Presented at the 2010 Jackson Hole 
Symposium, as published in Macroeconomic Challenges: the 
Decade Ahead, Federal Reserve Bank of Kansas City.
“Phillips Curves, Expectations of Inﬂ  ation, and Optimal 
Unemployment over Time,” by Edmund S. Phelps, 1967.  
Economica, vol. 34.
“Prices and Unit Labor Costs: A New Test of Price Sticki-
ness,” by Argia Sbordone, 2002.  Journal of Monetary Econom-
ics, vol. 49.
2011-17.indd   1 9/7/2011   11:29:22 AMKyle Fee is a research analyst at the Federal Reserve Bank of Cleveland, and Mark E. Schweitzer senior vice president and director of re-
search at the Bank. The views they express here are theirs and not necessarily those of the Federal Reserve Bank of Cleveland or the Board 
of Governors of the Federal Reserve System or its staff.
Economic Commentary is published by the Research Department of the Federal Reserve Bank of Cleveland. To receive copies or be placed 
on the mailing list, e-mail your request to 4d.subscriptions@clev.frb.org or fax it to 216.579.3050. Economic Commentary is also available 
on the Cleveland Fed’s Web site at www.clevelandfed.org/research. 
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2011-17.indd   2 9/7/2011   11:29:25 AM

Unemployment, labor costs, and recessions: implications for the inflation outlook

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Unemployment, labor costs, and recessions: implications for the inflation outlook

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