Inflation Expectations, Wages and Jobs: Connecting the Dots

Inflation expectations are as critical as actual inflation data. Surveys around the world regularly measure what households and businesses expect inflation to look like in the months or years ahead. The reason is simple:

Imagine a worker who believes inflation will rise. That worker has every incentive to negotiate a higher salary to protect purchasing power. If enough people demand higher wages, companies face increased labour costs. To offset these costs, businesses raise prices, which feeds back into inflation. Consumers then face higher prices, reinforcing the belief that inflation is rising. This cycle, called the wage-inflation spiral, is a key concern for central banks.

Historically, the 1970s US experience provides a clear example. When consumers and firms expected inflation to remain high, wage negotiations and price adjustments accelerated, leading to persistent inflation above 10%. Similarly, Japan in the 1980s experienced wage expectations that contributed to asset price inflation, followed by decades of stagnation when expectations collapsed.

Behavioral economics explains this phenomenon further: human decision-making is influenced by expectations, peer behaviour and perceived trends, which can amplify economic cycles.

Surveys like the University of Michigan Consumer Sentiment, the ECB’s Survey of Professional Forecasters and New Zealand’s Reserve Bank inflation expectations measure are vital for tracking these expectations and anticipating future market dynamics.

The inflation-wage spiral operates through a chain reaction:

1. Rising inflation prompts wage negotiations.
2. Higher wages increase household spending.
3. Increased demand drives prices higher.
4. Higher prices trigger further wage demands.

Sectoral differences matter. In technology, rapid productivity gains can absorb wage growth without major inflation, whereas in services and manufacturing, rising wages often translate directly into higher prices. Post-pandemic US data showed wage growth accelerating in sectors like retail and logistics, creating pressure on headline CPI.

The Phillips Curve is a key concept in macroeconomics that illustrates the inverse relationship between inflation and unemployment. It provides insight into how labour markets, wages and prices interact, and it has important implications for monetary policy and financial markets.

The concept was first introduced by economist A.W. Phillips in 1958, based on historical data from the United Kingdom.

Economists later generalized this relationship to overall price inflation, showing that tight labour markets often lead to higher inflation, while weak labour markets can suppress it.

The Phillips Curve suggests a trade-off: policymakers could potentially reduce unemployment at the cost of higher inflation or accept higher unemployment to keep inflation low. The reasoning is straightforward: when unemployment is low, workers gain bargaining power, pushing wages up. Businesses often pass these costs onto consumers, driving inflation. Conversely, when unemployment is high, wage pressures ease, leading to slower price growth.

As such, the Philips curve is downward-sloping, showing the temporary trade-off between unemployment and inflation.

Note that Long-Run Phillips Curve is vertical at the natural rate of unemployment, indicating that monetary policy cannot permanently reduce unemployment below this level. But we will leave that for another discussion.

In real world, the Phillips Curve relationship is more complicated. For example, during the 1970s stagflation in the U.S., high inflation occurred alongside high unemployment, largely due to supply shocks like oil price spikes. In more recent years, countries such as Japan and the U.S. have experienced low unemployment without significant inflation, reflecting factors like globalization, automation and anchored inflation expectations.

But the Phillips Curve remains central to monetary policy. Central banks monitor labour market tightness, wage growth and inflation to guide interest rate decisions. Traders and investors also watch these signals, as they affect equities, bonds and currencies. For instance, rising wage growth can increase expectations of central bank tightening, impacting bond yields and equity valuations.

In summary, the Phillips Curve links unemployment, wages and inflation, providing a framework for understanding labour market dynamics and policy decisions. While the trade-off it describes is not always stable or predictable, the curve remains a vital tool for economists, policymakers and market participants seeking to anticipate how changes in the labour market may influence asset prices and monetary policy.

Central banks operate at the intersection of two critical economic objectives: maintaining price stability and supporting employment. Striking the right balance between these goals is challenging, as actions that cool inflation can slow growth and increase unemployment, while measures to stimulate employment can risk higher inflation. To navigate these trade-offs, central banks employ a variety of monetary policy tools, both conventional and unconventional.

By raising or lowering the policy rate, central banks influence borrowing costs for businesses and households, thereby impacting spending, investment and consumption.

For example, when the central bank raises rates, loans become more expensive, consumer spending slows and economic growth moderates, which can help contain inflation in expense of lower employment. Conversely, lowering rates encourages borrowing and spending, supporting employment and economic activity, hence could fuel inflation.

Historical examples illustrate the power and limitations of interest rate policy. In the early 1980s, Paul Volcker, then Chairman of the Federal Reserve, raised U.S. interest rates dramatically to combat double-digit inflation. The move triggered a severe recession, increasing unemployment in the short term, but ultimately succeeded in restoring price stability and anchoring inflation expectations for decades to come. This episode underscores how interest rate policy can be painful but necessary to achieve long-term economic stability.

When conventional interest rate tools reach their limits—particularly in low-rate environments—central banks turn to unconventional measures, most notably quantitative easing (QE) or quantitative tightening (QT).

QT, the reverse process, reduces the central bank’s balance sheet to remove excess liquidity and contain inflationary pressures, while restricting employment.

Following the 2008 Global Financial Crisis, the Federal Reserve, the Bank of England (BoE) and the European Central Bank (ECB) implemented large-scale QE programs. These measures helped stabilize financial markets, restore confidence and prevent inflation from falling to dangerously low levels, all while supporting economic recovery and employment. The Bank of Japan (BoJ) similarly used QE in conjunction with negative interest rates under Governor Haruhiko Kuroda, attempting to stimulate inflation and growth during a prolonged low-growth period.

By signaling their anticipated future policy moves—such as keeping rates low for an extended period or outlining a path of gradual hikes—central banks aim to reduce uncertainty and guide the decisions of businesses, investors and consumers. Clear communication can stabilize markets by aligning expectations with policy objectives, while ambiguous guidance – and / or lack of credibility - can exacerbate volatility.

Several historical episodes highlight how central banks navigate their dual mandate:

1. Ben Bernanke (US, 2008-2009): Faced with a collapsing financial system, Bernanke deployed QE, forward guidance and near-zero interest rates to prevent deflation and support employment.
2. Haruhiko Kuroda (Japan, 2010s): With persistent low inflation and stagnant growth, Kuroda used negative rates and QQE (Quantitative and Qualitative Easing) to stimulate spending and investment.
3. ECB and BoE (post-GFC): Both central banks implemented QE to restore confidence in financial markets, lower borrowing costs and prevent disinflation from derailing economic recovery.

Because central banks constantly face trade-offs, raising rates too aggressively can curb inflation but risk a recession and higher unemployment. Overstimulating the economy, on the other hand, can boost employment temporarily but lead to runaway inflation. Modern central banks also contend with global factors: cross-border capital flows, currency valuation and supply shocks, which can limit the effectiveness of domestic monetary policy.

Additionally, unconventional tools like QE and negative interest rates carry long-term risks. They can distort asset prices, encourage excessive risk-taking and complicate future policy normalization. Forward guidance requires credibility; if markets doubt the central bank’s commitment, signals may fail to influence expectations effectively.

When inflation is below target, the rate cuts and QE work well. But when inflation is above target, central banks face a dilemma. They cannot simply cut rates even if jobs data is soft, because wage growth could perpetuate inflation.

Since the post-pandemic period, when inflation surged globally, markets react more to wage data than raw jobs numbers, highlighting the importance of expectations management.

• Japan: Publishes Shunto outcomes (annual wage negotiations) and monthly employment stats.
• Eurozone: ECB tracks quarterly wage growth and monthly unemployment.
• UK: Monthly employment and wages data.
• US: NFP Friday is iconic, releasing non-farm payrolls, unemployment rate, participation rate and wage growth.

Released on the first Friday of each month by the U.S. Bureau of Labor Statistics, the NFP report provides a comprehensive snapshot of the U.S. labour market, including total payroll additions, the unemployment rate, participation rate and average hourly earnings. While the report focuses on U.S. employment, its influence extends far beyond American borders, largely due to the U.S. dollar’s status as the world’s primary reserve currency.

The U.S. dollar is the benchmark for international trade, a key denominator for commodities, and the base currency for global debt markets. This means that any data that could influence U.S. monetary policy has ripple effects worldwide. Investors across Europe, Asia and emerging markets closely monitor NFP data to assess the potential direction of Federal Reserve interest rates. Even non-U.S. investors with no direct exposure to the American labor market adjust their portfolios in anticipation of the Fed’s reaction to the labour report.

• When the NFP report shows weaker-than-expected job growth, it suggests the U.S. economy may be slowing. Markets often interpret this as an increased likelihood that the Fed will cut interest rates to stimulate growth. Lower expected rates tend to reduce yields on U.S. Treasuries, which has several knock-on effects: equities often rise because lower rates reduce the discount rate applied to corporate earnings; the U.S. dollar may weaken, benefiting other currencies; and commodities priced in dollars, such as oil and gold, may appreciate.
• Conversely, stronger-than-expected employment data signals a robust labour market, potentially prompting the Fed to maintain or even raise rates to prevent overheating. In this scenario, Treasury yields rise, equities may face headwinds due to higher discount rates and borrowing costs and the U.S. dollar often strengthens, affecting global trade and investment flows.

This brings us to the famous saying ‘good news is bad news’ or ‘bad news is good news’.

One of the paradoxical aspects of NFP Fridays is that “bad” economic news can sometimes be positive for markets, while “good” news can be negative. This occurs because markets often react not to the data itself, but to the expected monetary policy implications of that data. Traders frequently use the phrase “bad news is good news” to describe this phenomenon.

• Equities: Lower rates generally support valuations; tech stocks are particularly sensitive to discount rates. Weak jobs data suggest lower rates hence push yields lower and boost equity valuations.
• Bonds: Weak jobs data lead to dovish expectations and lower yields, while strong employment and wages back hawkish Fed expectations and lead to higher yields.
• FX: USD valuation reacts to expected Fed moves, impacting commodities and global trade. The dollar appreciates when traders expect higher interest rates and depreciates when traders anticipate lower interest rates.

• Rising wages can create sustained inflationary pressure: higher household income boosts spending, which pushes up prices, potentially fueling a wage-price spiral. Investors monitor wage growth closely because it signals whether central banks may tighten monetary policy. Accelerating wages in a high-inflation environment can lead to higher bond yields, a stronger currency and downward pressure on interest-sensitive equities.
• In contrast, during low-inflation periods, such as after the Global Financial Crisis, overall employment figures dominated market sentiment. The Non-Farm Payroll (NFP) report became a key driver of expectations: strong job growth suggested economic recovery, while weaker data pointed to continued central bank stimulus. In these environments, wages mattered less because inflationary pressures were subdued, giving policymakers more flexibility.

Ultimately, the relative importance of wages versus jobs depends on the economic context. When inflation is high, wage data can outweigh employment numbers in influencing markets and shaping expectations for central bank action. Conversely, in low-inflation periods, labor market growth plays the leading role in guiding investor sentiment.

Post-pandemic inflation, higher wages, tense geopolitical environment and weak global growth prospects cause a serious dilemma for central banks.

Should the Fed cut rates to prevent unemployment to spike, or should it refrain from cutting rates to avoid inflation going out of control?

Should inflation or unemployment weigh heavier?

What if the choices that the Fed will make are not the right ones?

What if the Fed’s credibility is weakened?

The content in this article is provided for educational purposes only. It does not constitute investment advice, financial recommendations, or promotional material.