Recent Changes in the Unemployment Gap

Here is a graph of the deviation of the unemployment rate from its natural rate, i.e. (UN-UN*), where UN* is the CBO’s estimate of the natural rate of unemployment (the NAIRU, or non-accelerating inflation rate of unemployment):

Remember that negative numbers represent low unemployment and positive numbers high unemployment. Notice how steadily the gap has been declining over the time period since the end of 2003. At the end of the first quarter of 2005 the natural rate of unemployment was 5.2% and the unemployment rate 5.3% for a gap of .1%.

If you are the Fed and your job is to assess the overall health of the labor market and you see this diagram, what do you conclude? There are two views of the economy right now, one that says the underlying economy is strong though there are some noisy signals. This diagram would support that view.

But suppose you disagree. Why would you argue this mis-measures the true state of the labor market? There are two possibilities. The first is that the natural rate is mis-measured. The CBO has not changed its natural rate estimate of 5.2% since March of 1996. Prior to that it was changed frequently. Has the natural rate changed? One reason it would vary is changes in the age distribution of the population, but significant changes in the age distribution do not appear until after 2010 as shown here so that is an unlikely explanation.

The other possibility is that phenomena such as discouraged workers and underemployed workers (people working part-time wishing they could work full-time or working in an area different from their primary skill) cause the measured unemployment rate to be lower than its true value making the labor market appear stronger than it really is. If I wanted to argue that the data do not represent the true state of the labor market, I would focus here rather than the natural rate (or make the point that the average misses the high level of unemployment among some demographic groups).

But from a policy perspective this misses the point. The Fed understands that the “thermometer” it uses to take the temperature of the labor market may not give the true temperature. It may read 85 degrees when it’s really 91. But it still tells the Fed whether the labor market is getting hotter or colder which is what it needs to know to determine the appropriate course for monetary policy. It doesn’t matter if the thermometer is off by a few degrees, you can still tell whether the temperature is rising or falling. As the Fed looks at the data in the diagram, it sees a labor market that is getting hotter irrespective of whether the actual measure should be higher or lower.

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