Unemployment Rate

What Is The Unemployment Rate?

The unemployment rate is the percentage of unemployed workers in the labor force.
People are considered unemployed if they are able and willing to work but does not
have a job.

The unemployment rate is a countercyclical indicator. This means it decreases in a

growing economy and increases in a slowing economy.

According to the RBA, there are three different types of Unemployment. These three
are Structural, Cyclical and Frictional Unemployment.

Low unemployment is one of the key mandates of many central banks. Higher
employment means people have more money to spend.

Having more money to spend means an increase in the standards of living. BUT, low
unemployment is not always a good thing.

Did you know that the US economy fell into recession in three of their last four
hiking cycles? In these four cases some believe the FED allowed the economy to
overheat.

Some say rapidly advancing wages due to low unemployment caused an overheated
economy. This caused the FED to hike rates very rapidly which caused the
recessions.

That is why too low unemployment can be just as bad as too high unemployment.

Why Central Banks Care About The Unemployment Rate

The answer to this question brings us back to inflation and growth.

In 1958 A.W. Phillips made an important economic observation. His research showed
that there is an inverse correlation between inflation and unemployment.

His theory was called the Phillips Curve. The Phillips curve showed two things:

High unemployment results in low inflation

Low unemployment results in high inflation
The theory revealed the importance between aggregate demand (growth), unemployment
and inflation. When policy caused economic growth more jobs are needed.

More jobs mean more money in people’s pockets which means more spending. The
increase in spending increases the demand for goods which increases inflation.

Many central banks adopted the Phillips Curve theory to guide monetary policy. But
the stagflation of the 1970’s and the boom of the 1990’s showed there was a
disconnect in the theory.

During the 1970’s there was high inflation accompanied by high unemployment. During
the 1990’s there was low inflation accompanied by low unemployment.

This led economists to find reasons for the breakdown of the Phillips Curve.
Economists Milton Friedman and Edmund Phelps came up with a theory to explain this.

They argued that the Phillips curve was only reliable and accurate in the short
run. In the long run, unemployment will always settle at a “natural rate” despite
the inflation rate.

It’s also referred to as the NAIRU (non-accelerating inflation rate of

unemployment). This is the unemployment rate to which an economy will naturally
gravitate towards.

The natural rate of unemployment for developed countries is believed to be between

4.5% and 5.0%. An unemployment rate equal to the natural rate is considered as full
employment.

Relationship Between Unemployment And Interest Rates

We know central bankers are concerned about high and low unemployment. Both can
cause severe consequences on an economy.

For this reason, unemployment is a very closely watched indicator by central banks.
Not only because it forms part of their mandates, but because of its effects on an
economy.

Changes in the employment levels act as a barometer for economic health. A healthy
economy boasts low unemployment and struggling economies have higher unemployment.

This is due in part to wages. When an economy is healthy and labour markets are
tight workers can expect higher wages.

Wage inflation is one of the major reasons for increases in inflation. This is
because wages can affect both cost-push and demand-pull inflation.

Cost-Push Inflation: Increased labour costs pushes up production costs causing

businesses to raise prices.

Demand-Pull Inflation: As workers earn more they spend more. When the increase in
demand for goods surpass the supply, prices increase.

The ECB considers wage growth as a precondition for sustained increases in

inflation.

Contrastingly, central banks are also worried about high unemployment for the
opposite reasons.

If wages don’t rise in step with inflation it will impact consumer spending. A drop
in consumer spending will cause a slowdown in economic growth etc.

All this info gives traders a unique advantage in their Fundamental Analysis.

Strong labour markets normally require higher interest rates. Whereas weaker labour
markets normally require lower interest rates.

The infamous Non-Farm Payroll (NFP) is testament to the importance of labour data.
The NFP is probably the most watched and traded news event of any other indicator.

This is not surprising considering that unemployment is such a big focus to the
FED.

Putting It All Together

From the above information one can easily see that central bankers have very
difficult jobs.
Their monetary policy decisions guide economies through various business cycles.
Central banks need to make tricky decisions to achieve ideal economic conditions.

Some economists believe the ideal conditions for developed economies are namely:

Real GDP growth of between 2% to 3%

Core Inflation close to 2%
Unemployment rates of between 4.5% to 5.0
The challenge is that GDP, inflation and employment are all connected and
intertwined. A fall or rise in one of those three directly or indirectly affects
the others.

That is why these three indicators are the most important ones for traders. They
provide essential fundamental pieces of the economic puzzle.

By following these indicators, we can anticipate future interest rate moves.

Action To Take
What can you do to start using these three indicators in your Fundamental Analysis?

Find an economic calendar and see when any of these three indicators are released.
You will be able to find plenty of free economic calendars available on the
internet. Your broker may even have one of their own as well.

See how the markets react when these three indicators are released.
Make sure to read analyst remarks about these releases before and after the events.
This will give you an idea of how the market relates to these events.

It will also help you gain insight about which elements are important.

Start to build a big picture view of monetary policy.

Try and anticipate which actions central banks might take due to incoming data. In
the beginning read up on investment bank analysis about future interest rates.

This will give you a framework for how the markets analyse and forecast interest
rates.

By following these three simple steps can help you in your Fundamental Analysis.
Plus, once you have the basics in place you can expand your knowledge of other
indicators.

We wish you all the best with your Fundamental Analysis.

If you have any questions or comments, feel free to let us know in the comment box
below.

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