The optimal rate of unemployment, or the level that keeps inflation stable, is higher than most currently think. That’s the conclusion of Robert J. Gordon, an economics professor at Northwestern University.
“This result is important news for the Fed,” Gordon wrote in an August paper for the National Bureau of Economic Research. “There may be less slack in the U. S. labor market than is generally assumed, and it may be unrealistic to maintain the widespread assumption that the unemployment rate can be pushed down to 5.0 percent without igniting an acceleration of inflation.”
Monetary policy is designed to get the economy to its equilibrium level. Too-weak growth that leads to an increase in unemployment and a drop in inflation can be addressed by lowering interest rates and, in an extreme case, pumping more money into financial markets as the Federal Reserve has been doing since 2008. If you have too much growth and inflation, policy makers can step on the brakes by raising rates.
But what if central bankers are looking at the wrong speed limit sign? What if the optimal level of joblessness is determined more by those that have been out of work for 26 weeks or less? This would be the rate that represents the effects of so-called cyclical forces of a recession and its aftermath. The rate for those out of work for 27 weeks or more may represent a more structural, or permanent, change in the economy that cannot be influenced by monetary policy without stoking inflation.
Gordon raises an interesting point. Tweaking the Phillips Curve, which depicts the relationship between unemployment and inflation, and substituting short-run unemployment — 26 weeks or less — for total unemployment, Gordon’s research was able to predict the change in prices over the past 16 years to within one-quarter of a percentage point. That means that, contrary to what Gordon calls a “widely believed” assumption, the relationship between prices and joblessness hasn’t broken down.
Since 1996 through the first quarter of 2013, short-run unemployment ranged within a fairly narrow range from 3.9 percent to 4.4 percent, based on Gordon’s model. Joblessness climbed as long-run unemployment worsened with the last recession and has remained high.
Because of that, the equilibrium level of unemployment increased from 4.8 percent in 2006 to 6.5 percent in the first quarter of this year, Gordon found.
If over the next five years the Fed tries to drive the unemployment rate down to 5 percent — a level last seen in 2008 — it will create a “very slow acceleration of inflation that will reach between 3.5 and 3.8 percent ten years from now,” Gordon finds.