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Another monthly jobs report, another growing chorus worried that we might be employing too many people and we should hold back the economy lest it overheats. It was announced Friday that 164,000 new jobs were added in April, and the unemployment rate reached 3.9 percent.
It has been 18 years since unemployment was under 4 percent. As unemployment continues to fall, people wonder, how low could it go?
And what if it gets below the dreaded “natural rate of unemployment” that economists like to talk about?
The idea that there is a rate of unemployment, somewhere in the range of 5 to 6 percent, that’s essential in order for the economy to function smoothly — without rapidly overheating — has been broadly accepted by economists and economic commentators since the 1960s.
Yet there have always been dissenters, and more and more people are looking at this argument with a critical eye. One turning point may be a recent paper by Olivier Blanchard, the respected former chief economist of the International Monetary Fund. He argues that there’s enough evidence the economy can function well with much lower unemployment without inflation spiraling that the Federal Reserve should “keep an open mind” about whether the natural rate even exists.
Where did the idea of a “natural” rate of unemployment come from? The more technical term is “non-accelerating inflation rate of unemployment,” often rendered in shorthand as NAIRU. It’s described to undergraduates — in Blanchard’s popular macroeconomics textbook, for instance — as “the rate of unemployment required to keep the inflation rate constant.” The term was coined in Milton Friedman’s famous 1968 presidential address to the American Economics Association, “The Role of Monetary Policy.”
Increasing dissent on an issue once thought settled
Some economists have long grumbled about the idea of a natural rate of unemployment. Yet after Great Recession, these sub rosa rumblings are starting to go public. The first problem with this rate is that nobody can determine it with any accuracy. When economists say it’s 5 or 6 percent, they are basically guessing. Actual data from the real-world economy keeps demonstrating that employment of lower than 5 percent, and now even lower than 4 percent, can persist without harm.
Worse, when economists try to pick a “natural rate,” they err in the same direction every time — the direction that hurts workers. Look, below, at the estimates of the natural rate of unemployment as predicted by Federal Reserve economists. Every quarter, Fed economists predict unemployment over the next three years as well as the “long run” rate, the natural rate that unemployment would need to stay at in order to for inflation to be stable.
Here’s a chart of their guesses of the natural rate four years out and the actual unemployment rate that occurred.
The Y axis is the unemployment rate. The red line is the guess made four years earlier by the Fed as to what the long-run, natural rate of unemployment would be. The blue line is the actual unemployment rate. As we can see, the Fed failed to predict that unemployment could go as low as it did.
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As unemployment drops, it is easy to infer that inflation would follow. When there are fewer available workers, they can demand higher wages to take new jobs. And all kinds of economists incorporate this argument into their work. This is what many people generally think the “natural rate” debate is about.
But the actual natural rate thesis is more complicated, and makes some claims about how economic growth should behave. As Blanchard notes, the natural rate hypothesis actually consists of two interlocking propositions.
The first is the idea that there is a natural rate of unemployment that a well-functioning economy gravitates toward. Policy can’t get us below a certain level without inflation taking off. The best we can do for unemployment, therefore, is to ease fluctuations around this natural path.
And it follows that this is true more broadly about growth: There is a built-in rate of growth, given certain inputs like technology and educational levels, that policymakers can’t push beyond without generating increasing inflation, and that a well-functioning economy will settle on.
Yet our economy since the Great Recession does not appear to shifted back toward any kind of “natural” path of steady growth. Indeed, we never really recovered from the Great Recession. Once the recession started growth downshifted, and we continue to follow a low growth path. There was a massive break in the path of our economy —and the problem was even worse for Europe.
Milton Friedman was debunking the idea of a stable trade-off between unemployment and inflation
The second hypothesis of the natural rate argues that deviations from full employment lead to shifts in the rate of inflation — it will accelerate. “A rising rate of inflation may reduce unemployment, a high rate will not” is how Friedman put it in his address. This was a response to the idea that there was a stable trade-off between the rate of inflation and the rate of unemployment.
Friedman argued that this relationship was temporary, and would break down as expectations of inflation were absorbed into the inflation rates. Economists responded by absorbing this potential for inflation to accelerate because of expectations into their models.
But even as it became conventional wisdom, the supposed relationship between unemployment and increasing or decreasing rates of inflation was breaking down — notably in the 1990s. Unemployment got below 4 percent in 2000 without inflation taking off. Since the onset of Great Recession, the gap between theory and reality has only grown.
As unemployment rose, as the recession kicked in, the natural-rate theory would predict inflation to collapse, possibly to the point of deflation. Then during the slow recovery, we’d also expect inflation to pick up again. Yet neither happened; today, inflation appears to be well anchored at just below 2 percent. Economist Christian Friedrich, of the Bank of Canada, describes these two events as the “twin puzzles” of inflation in the Great Recession.
A range of possible “natural” rates so broad as to be useless
In the final year of President Obama’s term, the Council of Economic Advisers sought to quantify the degree to which the relationship between inflation and employment broke down. The ability of unemployment to predict changes in inflation is essentially zero over the past 20 years, they found. As a result, there’s no ability to predict a range, much less a rate, of natural unemployment. They conclude that the “50-percent confidence band in 2014 ranges from 4.3 to 6.1” for the natural rate of unemployment.
That estimate range is so vast it simply can’t guide policy.
What caused this breakdown is open to debate. Blanchard presents evidence that when inflation is very low and predictable, it doesn’t impact consumers’ decision-making. Consumers appear to “now ignore inflation unless some large change, such as a change in gas or food prices, takes place,” he writes. If that’s true, there’s more room for unemployment to go lower.
Once we see how weak the foundations for the natural rate of unemployment are, other arguments for pursuing rates of unemployment economists once thought impossible become more clear. Wages can increase at the expense of corporate profits without causing inflation. Indeed, since 2014 we are seeing an increase in the share of the economy that goes to labor.
Even better, lower unemployment doesn’t just help workers: It can spur overall growth. As the economist J.W. Mason argues, as we approach full employment incentives emerge for greater investment in labor-saving productivity, as companies seek to keep labor costs in check as workers demand more. This productivity increase stimulates yet more growth.
The harder we push on improving output and employment, the more we learn how much we can achieve on those two fronts. That hopeful idea is the polar opposite of a natural, unalterable rate of unemployment. And it’s an idea and attitude that we need to embrace if we’re to have a shot at fully recovering from the wreckage of the Great Recession.
Mike Konczal, a Vox columnist, is a fellow with the Roosevelt Institute, where he works on financial reform, unemployment, inequality, and a progressive vision of the economy. He blogs at Rortybomb and is on Twitter @rortybomb.
The Big Idea is Vox’s home for smart discussion of the most important issues and ideas in politics, science, and culture — typically by outside contributors. If you have an idea for a piece, pitch us at thebigidea@vox.com.
