What is the Natural Rate of Unemployment?

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If you listen to central bankers, they seem obsessed with the labor market. To some extent, this seems understandable. The Federal Reserve is tasked with the dual goals of price stability and full employment. It therefore makes sense that they would spend a lot of time thinking and talking about labor markets and the unemployment rate. However, their obsession with the labor market isn’t simply about whether they are achieving their goals or what they need to do to achieve their goals. Their obsession seems to be predicated on a belief that we can understand the future path of inflation by looking at the labor market and, in particular, the unemployment rate.

What makes the central bank obsession with the labor market particularly odd is that this seems like an idea that only an economist could understand. This is partly (but only partly) a communication issue. Central bankers seem really bad at communicating what they mean. When you listen to statements from these policymakers, it seems like the argument they are making is that their policy affects the labor market and unemployment and any change in unemployment then has an effect on inflation. To the casual observer is therefore seems like central bankers are saying that we need to reduce unemployment to increase the inflation rate and we need to increase unemployment to reduce inflation.

Not surprisingly, the casual observer finds this idea bizarre. Political commentary provides some evidence. Commentary from the left often reads like “the Fed says you have to lose your job so that inflation can come down.” This type of argument also gives way to political arguments that frame the policy choice as one of choosing high inflation or high unemployment — a false choice, at least in the long run. Commentary from the right often expresses skepticism that the central bank can have much effect on employment at all and encourages the central bank to focus on inflation.

So where does this idea come from?

This way of thinking about policy seems to be based on this idea that there is a Non-Accelerating Inflation Rate of Unemployment (NAIRU), which extended Milton Friedman’s idea of the “natural rate” of unemployment that I have previously discussed. Nonetheless, it is important to distinguish between the way in which policymakers use this concept and the way in which the concept was originally introduced and described.

Let’s start with policymakers. The way that policymakers think about this is as follows. When there is excess productive capacity in the economy, unemployment will tend to be high and inflation will tend to decline. In that sort of environment, expansionary monetary policy can increase economic activity and reduce unemployment. Inflation will also rise, but since it had previously declined, it is only rising back to its target. Thus, it is not so much that unemployment is having any causal impact on inflation, but rather that the unemployment rate is correlated with the degree of excess capacity.

According to this view, expansionary policy can only be effective up until the point at which total production in the economy is consistent with its potential (the level it would attain in the counterfactual world without any frictions). This potential level of production is associated with the NAIRU. Expansionary monetary policy can push production above potential and the unemployment rate below NAIRU, but only temporarily. In addition, this expansionary policy will also cause higher inflation. Any attempt to keep the unemployment rate persistently below NAIRU will cause ever-increasing rates of inflation.

This idea sounds simple enough and perhaps even compelling. However, there are some notable flaws here. First, what policymakers really seem to care about is deviations of actual production from potential, or the “output gap.” This is notoriously difficult to measure, which can lead to policy errors. The unemployment rate is a proxy for this “output gap”, but there is no guarantee that the correlation between unemployment and the output gap is constant over time. Focusing on the unemployment rate can therefore potentially lead policymakers astray. Second, a closely related point is that there is no guarantee that NAIRU is constant over time. If NAIRU is changing over time, then policymakers are trying to hit a moving target. Third, the implicit assumption being made by those who advocate this view of policy is that policymakers have the tools to keep the unemployment rate close to NAIRU in real-time even though monetary policy cannot pin down real variables over time.

Ultimately, however, the bigger issue that advocates of basing policy around NAIRU seem to miss is actually the fundamental point of Friedman’s argument. Friedman’s point was about the limits to policy. Societies face real resource constraints that monetary policy cannot solve. Although monetary policy can potentially have success at increasing output and reducing unemployment, it cannot change the underlying fundamentals of the labor market. Monetary policy has limitations. Friedman’s natural rate of unemployment is a way of describing and outlining those limitations in the abstract. Yet, it is important to keep in mind that we don’t know the precise point in reality at which those limitations are reached. (We only tend to find out when significant policy errors are made.) Monetary policy must not try to do what it cannot do.

The development and use of the estimated NAIRU in policy comes from a different worldview. From Friedman’s description of the natural rate of unemployment, others see the possibility of discovering the true, underlying NAIRU. With the right tools and enough data, they believe that the correct NAIRU can be discovered. They do not consider that NAIRU is not something to be discovered, but rather is an invention.