The Inflation–Unemployment Puzzle: Why India Needs to Read Expectations When Jobs Cannot Tell the Whole Story.....

The Phillips Curve Meets the Reality of India's Informal Economy

The relationship between inflation and unemployment is traditionally explained through the Phillips Curve, which suggests that inflationary pressure tends to increase when unemployment falls and economic activity approaches its productive capacity. When more people find employment, household incomes rise, consumption increases and businesses gain greater pricing power. Conversely, rising unemployment generally weakens purchasing power, reduces consumption and moderates inflation. However, this relationship becomes considerably more complicated in India, where nearly 90% of employment is estimated to be informal. Unlike developed economies, where formal employment, wages and unemployment insurance provide relatively reliable indicators of economic conditions, India's labour market includes casual workers, self-employed individuals, agricultural labourers, unpaid family workers and people engaged in irregular employment. A person may be officially employed but earn insufficient income to support consumption, while another may be working fewer hours than desired. Consequently, a low unemployment rate does not necessarily indicate a tight labour market or strong aggregate demand. India's Periodic Labour Force Survey has reported unemployment of approximately 3.1% under the usual-status measure, while unemployment among young people aged 15–29 has been considerably higher, around 9.9%. Graduate unemployment has also remained a concern. These differences demonstrate why the headline unemployment rate cannot independently explain the relationship between inflation and economic activity. India's inflation problem must therefore be examined through employment quality, real wages, household purchasing power, underemployment and the distribution of income rather than simply the number of people classified as employed.

Why Unemployment Does Not Always Control Inflation

In an economy dominated by informal employment, inflation can remain elevated even when unemployment is relatively high. This happens because food, fuel, housing and essential services account for a substantial share of household expenditure, particularly among lower-income households. Rural households spend approximately 47% of their monthly consumption expenditure on food, compared with around 40% for urban households. Therefore, an increase in food prices can reduce disposable income and consumption of other goods without necessarily producing a corresponding increase in measured unemployment. Equally, higher prices can encourage workers to demand higher wages, but informal businesses may lack the financial capacity to increase wages proportionately. The result is a decline in real incomes rather than a conventional wage-price spiral. India's average daily earnings for casual labour increased from approximately ₹430 in 2024 to ₹453 in 2025, but nominal wage increases do not necessarily represent improvements in purchasing power when essential prices rise. Furthermore, self-employed workers may respond to declining demand by accepting lower margins, working longer hours or employing family members without additional compensation. These adjustments conceal economic distress in conventional labour statistics. Thus, unemployment may not increase even when household consumption weakens significantly. The relationship between inflation and unemployment in India is therefore mediated by real wages, informal employment, productivity and the capacity of businesses to pass higher costs to consumers.

How the RBI Distinguishes Transitory Inflation from Embedded Inflation

The Reserve Bank of India cannot depend exclusively on unemployment figures to determine whether inflation is temporary or becoming entrenched. Instead, it must examine the composition, persistence and transmission of price increases. India's flexible inflation-targeting framework aims at 4% consumer price inflation, with a tolerance band of 2–6%. A temporary increase in vegetable prices caused by an adverse monsoon, supply disruption or seasonal shortage does not necessarily justify a monetary tightening cycle. The RBI must assess whether such increases are spreading into other goods and services, influencing wages, changing business pricing decisions and altering household expectations. Food inflation is particularly important because food occupies a large share of household budgets and influences perceptions of the cost of living. However, the persistence of core inflation, which excludes food and fuel, can provide additional evidence of broader price pressures. The RBI also examines the breadth of inflation across consumption categories, inflation momentum, input costs, capacity utilisation, credit growth, liquidity conditions, wage movements and international commodity prices. If headline inflation rises because of a temporary supply shock while core inflation remains contained and demand is weak, the appropriate response may be to avoid unnecessary interest-rate increases. But if businesses repeatedly revise prices upwards, workers begin demanding compensation for anticipated inflation and households expect prices to continue rising, a temporary shock can become embedded in the economy. The distinction is not simply between food inflation and core inflation; it is between an isolated change in relative prices and a persistent change in the economy's price-setting behaviour.

Inflation Expectations May Be More Informative Than Unemployment

When unemployment statistics are unreliable indicators of economic slack, inflation expectations become particularly important for monetary policy. The RBI conducts household inflation expectation surveys to understand what consumers expect prices to do over the coming three months and one year. It also conducts consumer confidence surveys, professional forecaster surveys, industrial outlook surveys and capacity utilisation assessments. These indicators help identify whether inflation is changing actual economic behaviour. For instance, if households expect higher prices, they may advance purchases, reduce savings and increase present consumption. Businesses anticipating higher future costs may increase prices today, even before their input costs rise. Workers may seek higher wages to protect purchasing power, while lenders may demand higher interest rates to compensate for expected inflation. Such behaviour can make inflation self-reinforcing. The distinction between adaptive and forward-looking expectations is important here. Adaptive expectations are formed largely from past inflation, whereas rational or forward-looking expectations incorporate available information about future economic conditions and policy responses. In practice, households and businesses use a combination of both. If the RBI credibly communicates that temporary supply shocks will not be allowed to become persistent inflation, it can influence future price-setting decisions without necessarily causing a large increase in unemployment. This is particularly valuable in India, where raising interest rates cannot directly create additional food supplies or immediately improve agricultural productivity.

Interest Rates, Savings and the Supply-Side Response

The relationship between interest rates, savings, consumption and inflation is more complex than simply reducing demand through expensive borrowing. Higher interest rates can encourage households to save rather than consume, moderate credit-financed expenditure and reduce excessive demand. They can also strengthen the incentive for financial savings, improving the availability of funds for productive investment. However, higher borrowing costs can simultaneously discourage businesses from expanding capacity, increasing inventories or investing in new production. If supply is already constrained, excessive monetary tightening may reduce production and employment without proportionately reducing inflation. The RBI must therefore distinguish demand-driven inflation from supply-driven inflation and assess how monetary policy can influence their interaction. An economy with weak purchasing power, considerable underemployment and limited wage growth may not require aggressive demand suppression simply because food inflation has temporarily increased. Instead, monetary policy should prevent temporary price increases from changing long-term inflation expectations, while fiscal and supply-side policies improve storage, transportation, agricultural productivity and market availability. The objective should be to encourage savings, stabilise expectations and create conditions in which businesses can increase supply without anticipating continuously rising prices. Lower expected inflation can also reduce the nominal interest rates demanded by lenders over time, improving investment conditions and supporting employment.

The RBI's Real Challenge: Controlling Expectations Without Destroying Employment

India needs a monetary-policy framework that recognises the limitations of conventional unemployment statistics. The RBI should not interpret low unemployment as conclusive evidence of excessive demand, nor should it interpret weak employment conditions as proof that inflation will automatically decline. A better assessment combines real wage growth, household consumption, labour-force participation, employment quality, capacity utilisation, credit expansion, core inflation and inflation expectations. The September 2026 CPI inflation rate of 5.54%, with food inflation at 7.74%, illustrates why the composition of inflation matters as much as the headline number. At the same time, the 2025 PLFS unemployment rate of 3.1% among persons aged 15 and above does not establish that all sections of the labour market enjoy adequate employment or purchasing power. The RBI's ultimate responsibility is not to eliminate every temporary movement in prices through interest-rate changes, but to prevent such movements from becoming permanent expectations. Monetary credibility can reduce the incentive to purchase today merely because prices are expected to be higher tomorrow. This can moderate present demand, encourage savings and give producers greater confidence to invest in additional capacity. India's monetary-policy success should therefore be judged not merely by whether inflation returns to the 4% target or unemployment remains low, but by whether stable expectations allow real incomes, productive investment, employment and supply to grow together. In an informal economy, the most important signal may not be how many people are unemployed, but what households and businesses believe will happen to their incomes, prices and borrowing costs tomorrow.