How Is the Unemployment Rate Related to Inflation?

By Motley Fool Staff Markets Fool.com

There's clear proof that the U.S. economy is headed in the right direction. Last week, the U.S. Labor Department reported that the unemployment rate dropped in November to 4.6%.

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But while this is good in and of itself, it also has a side benefit. In this segment of Industry Focus: Financials, The Motley Fool's Gaby Lapera and John Maxfield dig into the relationship between unemployment and inflation, detailing in particular why a little more of the latter would improve the economic outlook even further.

A full transcript follows the video.

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This podcast was recorded on Dec. 5, 2016.

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Gaby Lapera: One of the thingsyou should look for is whenunemployment rates drop, inflation tends to tick up.

John Maxfield:That'sexactly right. That is why that 5% rate is so important, also. If unemployment falls below that 5% rate, the theory is that, what employers are going to have to do is start increasing their wages for the laborers. Andif you increase wages for laborers,you're putting more money in people's pockets. If you put more money in people's pockets, that allows them to go out and bid up the prices of goods and services. If you bid up the prices of goods andservices, you're creating inflation. So this is a good sign when you consider that inflation, the other side of the Federal Reserve responsibility, has been below its target rate. It came in at 1.6% in October. But theFederal Reserve is looking for a 2% inflation rate. So, that's coming in below. So, as these pressures in the labor market come to play, that istheoretically going to push that inflation number upcloser to what the Federal Reserve is looking for.

Lapera:Yeah. I will say, there is one figure that is not quite as heartening in this report,which is the youth unemployment rate. The youthunemployment rate peaked in 2010at 18.7%, and right now it's hovering around 12%. Which is not great, at all. Youthunemployment rate is consideredpeople who are not enrolled in school, who arehigh school graduates but have no college, and are between 16 to 24 years old. So, 12%,still not great. It is dropping,but it's something to keep in mind.

Let's talk a little bit aboutinterest rates. Janet Yellenis probably going to stick to what she said in November. Consumer confidence is up, in general, and unemployment is down. It seems like it might be time to start raising the interest rates.

Maxfield:That's right. Let me back up for one pointI want to make on inflation. In the United States, when you think about the last 40 years, inflation has really gotten a bad name. Thereason it has gotten such a bad name traces back to the 1970s and 1980s, when inflation shot up into double digits. It was like 18%-20% at the peak of the inflationary cycle at that time period. And that is not a good thing, because it's such an uncertain environment. Then you startthinking about the Weimar Republicand Germany and all those different things. But, you do want some inflation. The question is,how much inflation do you want? TheFederal Reserve says 2%. So, the question is, why do you want even some inflation? Why don't you just want perfect price stability? The reason is that,in the United States, our GDP -- and I'm sure listeners have heard this statistic a million times -- 70% of our GDP traces itself back to the consumer and consumerexpenditures.

When you think aboutconsumer expenditures,a lot of people buy things on debt. People buy houses on debt. I own a house. I actually don't own the house,Bank of Americaowns the house.(laughs) Same thing withmost people and cars. They buy them andthey get a loan for the car. Well, any time you're buying things on credit and you have inflation, that is making the cost of borrowing decrease each year. Let's say,mortgage rates right now are like 3.5%. Let's sayinflation goes up to 2%. That means the real cost to borrow is only 1.5%. Thatincentivizes people to borrow, which then pushes consumerexpenditures, which are 70% of the U.S. economy. That is why you do want some inflation, but you don't want it to get out of control, where you're adding uncertainty and impacting consumer confidence, onthe other side of that.

Every month, theFederal Reserve either has a meeting, or its chairwoman,Janet Yellen, has to testify before Congress. When she does that,or when they have a meeting and release the notes, they give an update on the perspective of what they'rethinking about in terms of interest rates.Janet Yellen came out last month and said, we will raise interest rates "relatively soon" if therecontinue to be positive metrics that suggest that the economy is improving. We just saw that, with that unemployment statistic. That is as straightforward a statistic as you can get to show the economy is improving. So,what this means is that --and you can never predict for surewhen the Fed is going to raise interest rates -- but it certainly suggests that, at the Fed's meeting this month, there is a very good chance that they will, in fact, do so.

Gaby Lapera has no position in any stocks mentioned. John Maxfield owns shares of Bank of America. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.