The Natural Rate of Unemployment

In the post below this one, Tim Duy talks about what the Fed will do. However, others are more worried about what the Fed ought to do, and Willem Buiter suggests that perhaps a rate increase is needed.

So let me argue against the types of interventionist policies I have been advocating, and present an argument that supports Willem Buiter. One of the keys is his contention that the natural rate of unemployment has been rising:

The natural rate of unemployment in the US is rising: the Fed should consider raising rates, by Willem Buiter: ...The latest labour market figures show a large fall in employment and an even larger fall in labour supply, resulting in an actual decline in the unemployment rate to 4.8%. There is also evidence to support the view that the natural (equilibrium) rate of unemployment in the US is increasing. The combination of a declining actual unemployment rate and a rising natural unemployment rate means that there are now higher domestic inflationary pressures associated with any observed level of employment and unemployment than before. ...

It makes economic sense that the US natural rate of unemployment is increasing, if only because of compositional changes in the labour force that are reducing, on average, its quality and employability. The post-9/11 imposition of additional obstacles to the immigration of skilled labour are one factor reducing labour force flexibility. So is the long-standing decline in the numeracy and literacy standards of the high-school graduates.

At the same time, the need for greater changes in the mix of skills and in the geographical and industrial distribution of employment associated with globalisation and accelerating technological change, have raised the degree of flexibility required to maintain the same amount of labour market pressure. The US is not responding, except defensively by threatening a retreat into protectionism. With mismatch unemployment and frictional unemployment rising, the natural rate of unemployment is rising in the US.

We can look at the evidence for a higher natural rate of unemployment also from the perspective of the path of potential output. Underlying total factor productivity growth in the US appears to be slowing down and with it the trend growth rate of potential output, raising the output gap corresponding to any level of observed output.

The reduction in labour supply is highly unlikely to reflect the so-called discouraged worker effect. ... The recession ... is far too young to have created an increase in discouraged worker disengagement from the labour force.

So with inflation too high and the natural rate of unemployment rising, the Fed should be thinking of hiking rates, not lowering them further.

Whether you believe Buiter's reasoning or not (see below for estimates of the factors that appear to change the natural rate), there is evidence from the academic journals that the natural rate of unemployment is highly variable over time. For example, consider this article by Thomas King and James Morley from the March, 2007 edition of the Journal of Monetary Economics:

In search of the natural rate of unemployment, by Thomas B. King and James Morley, JME, March 2007: ...1. Introduction The natural rate of unemployment is the long-run equilibrium in the labor market, and economists often appeal to it as a proxy for broader macroeconomic equilibrium. A measure of the natural rate is therefore potentially useful... In this paper, we present an estimate of the natural rate...

Our approach to estimating the natural rate [relies]... on the following definition given in Phelps (1994, p. 1):

[The 'natural rate of unemployment' is defined as] the current equilibrium steady-state rate, given the current capital stock and any other state variables. (It is the unemployment rate that, if it were the actual rate at the moment, would make the current rate of change of the associated equilibrium unemployment rate path equal zero.) In [this] theory, then, the equilibrium path of the unemployment rate is driven by a natural rate that is a variable of the system rather than a constant or a forcing function of time. The endogenous natural rate becomes the moving target that the equilibrium path constantly pursues.

Under this definition, which is closely related to Friedman's (1968) idea of the natural rate as the value “ground out by the Walrasian system,” the unemployment rate is determined by a stable dynamic process and, in the absence of exogenous shocks, converges to a unique steady-state equilibrium. Importantly, this equilibrium is itself endogenous, determined by technological, institutional, and demographic factors, and is therefore not necessarily constant over time. ...

We ... estimate the natural rate under Phelps's definition as the time-varying steady state of the unemployment rate. ... In contrast to many previous studies, our results suggest that the natural rate is quite volatile and support the idea that most macroeconomic activity reflects movements in long-run equilibrium, not from equilibrium. Indeed, movements in the natural rate account for over half of the variation in the post-War US unemployment rate. ...

To examine our estimated natural rate further, we consider whether it relates to a number of variables that economic theory suggests may be relevant. Consistent with recent search-based models of equilibrium unemployment, the most important determinants are unemployment benefits, labor productivity, real wages, and sectoral shifts in the labor market, with sectoral shifts having the largest estimated impact. Also, consistent with the short-run Phillips Curve, there is a strong negative relationship between inflation and the corresponding measure of cyclical unemployment.

Here is a picture of their estimate (actual unemployment is the faded line):

Here's the estimated Phillips curve:

And here's the bottom line:

7. Conclusion ...The results ... provide further support to the already large body of literature validating the existence of the short-run Phillips Curve. ... However, the results also clearly suggest that any tradeoff between cyclical unemployment and inflation is an issue of secondary importance when compared to the effects of movements in the natural rate itself. If one views unemployment at the natural rate as evidence of a market-clearing outcome, it must be inferred that shifts in labor-market equilibrium constitute the bulk of the variation in the unemployment rate. Thus, while movements away from the steady state are governed by a strong Phillips Curve relationship, a sizeable proportion of macroeconomic activity is governed by changes in the steady state, even over short horizons. To the extent that achievement of equilibrium in the labor market proxies for broader macroeconomic efficiency, this finding suggests that business cycles primarily reflect market-clearing adjustments to exogenously changing conditions.

With regard to macroeconomic policy, if the goal is to maintain the economy at full employment, the results in this paper yield a frustrating conclusion: the natural rate is a quickly moving target. If the economy responds slowly and uncertainly to monetary shocks, policymakers will have a hard time predicting the effects of policy. In order to do so accurately, one needs not only a model describing the response of economic variables to monetary changes, but also a model describing the behavior of the natural rate over time. From the analysis in this paper, relevant variables for such a model include changes in sectoral composition, unemployment benefits, and, to a lesser extent, productivity growth and real wages. ...

Again, this is not the only view -- there is a lot more evidence on both sides of the issue. From my reading of the evidence, I do not believe that a passive policy response to current conditions is warranted (and, given the current problems in the economy, I certainly don't think an increase in the target rate is needed to bring the real interest rate up to its natural level). The point is that it is possible to make a case for the view that much of the variation we see in the macroeconomy is an equilibrium response - and hence there is no need for policy intervention other than to control inflation - rather than a deviation from the equilibrium path that can be corrected through monetary and fiscal policy.

I hold the New Keynesian view that fluctuations we see are predominantly deviations from the equilibrium path rather than the Real Business Cycle view that fluctuations are mostly changes in equilibrium. Much of the split you hear from analysts - some advocating an aggressive policy response and others taking a hands off let it correct itself perspective - is due to this difference in beliefs about whether fluctuations are variations in equilibrium or deviations from equilibrium.

Why don't we know which it is? The simplest way to think about it is that we have one series, the unemployment rate, and we want to extract two pieces of information from it, trend movements in unemployment and the cycles in unemployment around the trend. However, we can't get two pieces of information from a single series without making identifying assumptions, and the assumptions that are made - all of which are defensible - change the answer that you get in terms of what is trend and what is cycle. There's a little more to it than this, but that's the heart of the problem.