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It’s commonly known that interest rates are indirectly related to unemployment. High interest rates can dampen economic activity and reduce employment, while low rates spur economic growth and encourage businesses to hire more workers. But this relationship isn’t as straightforward as it may seem, and there are many other factors that can overshadow it.
Key Takeaways
- Interest rates and unemployment theoretically share an inverse relationship.
- The Federal Reserve adjusts interest rates in response to broader economic situations, which may have unexpected outcomes on the labor market.
- Although the Fed cut rates during the Great Recession and the COVID-19 pandemic, the unemployment rate shot up.
The Basic Theory
Higher interest rates make it more expensive to borrow, tightening up the money supply in the economy. This leads businesses to cut back on hiring. Consumers also reduce spending, especially on discretionary items like luxury items, cars, and homes. The economy may experience slower growth and, therefore, higher unemployment.
Conversely, lower interest rates mean borrowing costs become cheaper and the money supply increases. Consumers are more likely to spend, increasing the demand for expensive, non-essential goods. Businesses may increase investments in their growth and hire more workers. As a result, unemployment drops.
This relationship between rates and unemployment is closely monitored in the U.S. by the Federal Reserve and is part of its dual mandate: achieving maximum employment and stable prices through its monetary policy. The Fed’s monetary policy is enacted through tools like its reserve requirements, which are the amounts of money that banks must keep at the Fed in reserve, and the federal funds rate, which is the target rate that banks lend to one another.
But, it isn’t always so cut-and-dry, according to Christopher Thornberg, economist and founding partner of Beacon Economics.
Important
The relationship between inflation and unemployment is explained in the Phillips curve. According to the model, unemployment is reduced when inflation increases and vice versa.
A Complicated Relationship
According to Thornberg, this “so-called inverse relationship” between rates and unemployment remains true, assuming all other factors remain constant. But things get complicated outside this vacuum, and what economists observe is sometimes contrary to what the core theory suggests.
“The expected relationship is not what you’re seeing in the data because the Federal Reserve is typically changing the federal funds rate on the basis of broader economic situations,” Thornberg said, citing major events like the Great Recession and the COVID-19 pandemic of 2020. The Federal Reserve used interest rates to help counter the effects of heavy unemployment that spread across the U.S.
“In theory, it helped, but not enough,” he added. “They cut the federal funds rate prior to the Great Recession from above 5% to functionally 0%, and the unemployment rate went from 4% to 10%.”
10.0%
The unemployment rate in October 2009, during the Great Recession. The rate fluctuated between 9.9% and 9.0% between November 2009 and September 2011.
That also occurred during the pandemic. The unemployment rate was 4.4% in March 2020 and jumped to 13.2% in May 2020. The Fed cut its target range to between 0% to 0.25% on March 16, 2020, only raising it by 25 basis points two years later. The unemployment rate remained above 6.7% in December 2020 before dropping down to 6.4% the following month.
Short- vs. Long-Term Impacts
It’s also difficult to gauge the effect of rate changes, especially when other variables are at play. While short-term rate changes may not have an immediate impact, long-term ones can make a big dent in the labor market in the long run. But interest rates aren’t the only factor that can affect the labor market.
Aside from interest rate cuts (or increases), other key factors that can influence the labor market include:
- Business activity and investment
- Government benefits and fiscal policy
- Changes in the labor market
- Innovations in industry and technology
- Supply and demand
Note
Annual inflation was 2.4% in May 2025, as measured by the Consumer Price Index (CPI). That’s a slight increase from 2.3% the previous month. Meanwhile, the core inflation rate in the U.S. (excluding food and energy) remained flat at 2.8%.
Unemployment Forecasts
As of June 2025, the U.S. unemployment rate was 4.1%, while the Fed’s target fed funds rate range was 4.25% to 4.50%. The Fed lowered its target range in December 2024 and remained positive about U.S. labor market conditions, saying they have “generally eased, and the unemployment rate has moved up but remains low.”
Beacon Economics expects the U.S. unemployment rate to range from 4.4% to 4.5% between the third quarter of 2025 and the first quarter of 2026. The Fed did not move on interest rates during its May 2025 meeting, but said it would monitor the economy before making any decision. The central bank also noted the risks of increased unemployment and inflation, saying that price growth remained “somewhat elevated.”
The Bottom Line
The relationship between interest rates and unemployment isn’t as simple as it’s made out to be. That’s because there are other factors at play, including broader economic circumstances that the Federal Reserve must consider when it executes its monetary policy.
