Every month, alongside the CPI release, central banks and economists scrutinise the labour market for clues about where inflation is heading. The logic is simple: when unemployment is low, employers compete for workers, wages rise, and businesses pass those higher costs on as higher prices — especially in labour-intensive services like restaurants, haircuts, and healthcare. This feedback loop is why the Federal Reserve, ECB, and Bank of England all include labour market indicators in their inflation frameworks.
The Phillips curve: the textbook relationship
The Phillips curve — named after New Zealand economist A.W. Phillips, who identified an empirical relationship between unemployment and wage inflation in 1958 — plots unemployment on the x-axis and inflation on the y-axis. The theory predicts a negative relationship: lower unemployment → higher inflation. The Federal Reserve's explainer on the Phillips curve describes how the relationship became a foundation of monetary policy in the 1960s and 1970s.
The problem: the curve has flattened dramatically since the 1980s. IMF research and BIS papers show that the same reduction in unemployment now generates far less inflation than it did in the 1970s. Better-anchored inflation expectations — created by credible central bank targets — are the most widely accepted explanation: if workers and firms believe the central bank will keep inflation at 2%, they don't demand large wage increases just because unemployment falls.
What happened in 2021–2024
The post-pandemic inflation surge was a test case for the Phillips curve. Unemployment fell rapidly from its 2020 peak: US unemployment hit 3.4% in early 2023, its lowest since 1969, while euro-area unemployment reached record lows. Yet by late 2023, inflation was falling sharply even as labour markets stayed tight — what some economists called a "soft landing" and others called a refutation of simple Phillips curve logic.
The IMF's October 2024 World Economic Outlook dedicated a chapter to the "last mile" of disinflation, arguing that tight labour markets remained a risk to completing disinflation but that other factors — falling goods prices, energy base effects, and supply-chain normalisation — had dominated. The BIS Annual Report 2024 similarly noted that services inflation persistence was the main residual challenge, driven by labour costs.
The metric to watch: unit labour costs
Wage growth alone is not inflationary if productivity rises at the same pace. What central banks actually watch is unit labour costs (ULC) — wage growth minus productivity growth. ULC growing at 3–4% in an economy targeting 2% inflation is a warning sign. The OECD publishes quarterly unit labour cost data for all member countries. In the euro area, the ECB Economic Bulletin tracks ULC alongside services CPI as the two key "last mile" indicators.