FRBSF Economic Letter
98-28; September 18, 1998
The Natural Rate, NAIRU, and Monetary Policy
The natural rate of unemployment is a key concept in modern macroeconomics.
Its use originated with Milton Friedman's 1968 Presidential Address to
the American Economic Association in which he argued that there is no
long-run trade-off between inflation and unemployment: As the economy
adjusts to any average rate of inflation, unemployment returns to its
"natural" rate. Higher inflation brings no benefit in terms
of lower average unemployment, nor does lower inflation involve any cost
in terms of higher average unemployment. Instead, the microeconomic structure
of labor markets and household and firm decisions affecting labor supply
and demand determine the natural rate of unemployment. If monetary policy
cannot affect the natural rate, then its appropriate role is to control
inflation and, in the short run, help stabilize the economy around the
natural rate. Doing so would be consistent with maintaining low and stable
inflation.
A second important unemployment rate is the "Non-Accelerating Inflation
Rate of Unemployment," or NAIRU. This is the unemployment rate consistent
with maintaining stable inflation. According to the standard macroeconomic
theory enshrined in most undergraduate textbooks, inflation will tend
to rise if the unemployment rate falls below the natural rate. Conversely,
when the unemployment rate rises above the natural rate, inflation tends
to fall. Thus, the natural rate and the NAIRU are often viewed as two
names for the same thing, providing an important benchmark for gauging
the state of the business cycle, the outlook for future inflation, and
the appropriate stance of monetary policy.
The overall unemployment rate in the U.S. has hovered around 4.5% of
the labor force so far this year. Much of the current debate over the
stance of monetary policy can be expressed in terms of a comparison between
this historically low rate and the NAIRU. If the NAIRU is above 4.5%,
then monetary policy may need to act to slow the economy to prevent a
future rise in inflation; if it is below 4.5%, then such a policy would
be unnecessary. Economists debate whether the natural rate has fallen
in recent years, and some argue that the whole concept of the natural
rate, or the NAIRU, is not useful in formulating monetary policy, an argument
critically discussed by Judd (1997). In this Economic Letter,
the factors that influence these two unemployment rates and their role
in the formulation of monetary policy are discussed.
Is the natural rate the
same thing as the NAIRU?
No. While the two are often viewed as synonymous, Estrella and Mishkin
(1998) argue that it is important to distinguish them. The natural rate
is the unemployment rate that would be observed once short-run cyclical
factors have played themselves out. Because wages and prices adjust sluggishly,
the natural rate can be viewed as the unemployment rate when wages have
had time to adjust to balance labor demand and supply. It depends on structural
factors characterizing the labor market and is generally assumed to change
slowly over time. Since cyclical factors can take significant time to
work themselves out, however, the natural rate may be less useful for
policymakers concerned about the outlook for inflation over the next year
or two.
The NAIRU, in Estrella and Mishkin's view, should be interpreted as
the unemployment rate consistent with steady inflation in the near term,
say, over the next 12 months. The level of unemployment consistent with
a steady inflation rate over such a time horizon can change significantly.
For example, if weather conditions push up food prices, the level of unemployment
consistent with a steady Consumer Price Index (CPI) inflation rate would
increase, representing an increase in the short-run NAIRU. An increase
in productivity that puts downward pressures on prices would lower the
short-run NAIRU. Hence, the level of unemployment in the absence of cyclical
factors need not be the same as the rate consistent with steady inflation
in the short-run, and the short-run NAIRU will fluctuate much more than
the natural rate.
Is the natural rate still 6%?
The average long-run unemployment rate measured since 1961 is 6.09%,
and during the 1980s and early 1990s, most economists placed the natural
rate quite near that, in the 6-6.5% range. But attempts to measure the
natural rate precisely are problematic, since we cannot observe it directly.
For example, Staiger, Stock, and Watson (1997) based a measure of the
natural rate for 1994.Q1 on the CPI measure of inflation, and found a
95% probability that it was between 3.9% and 7.6%! Using a measure of
core CPI inflation, this interval narrowed to 4.5% to 6.9%, still wide
enough to raise questions about its usefulness in policy discussions.
Figure 1 shows two additional
estimates of the natural rate, together with the actual total civilian
unemployment rate and the long-run average rate. The estimate labeled
Natural Rate 1 is obtained by removing an estimate of short-run cyclical
unemployment from the actual rate. This estimate assumes that any persistent
change in actual unemployment is associated with a change in the natural
rate. The estimate labeled Natural Rate 2 was constructed by Stuart Weiner
(1993), who combined evidence on the relationship between unemployment
and inflation with a disaggregated approach that accounts for shifts in
the composition of the labor force between different age/gender groups.
Although these estimates are quite different from point to point, they
do seem to move together broadly.
What causes the natural
rate to change?
It would seem obvious to answer this question by looking at the factors
affecting labor supply and demand, since the natural rate is the unemployment
rate when wages have adjusted to balance labor demand and labor supply.
But the labor market is not one homogeneous mass of workers, so one should
think of wages adjusting to balance demand and supply in the segmented
markets for skilled workers, for unskilled workers, for teenagers, for
adults, and so forth. The overall natural rate of unemployment will then
be affected by changes in the demand or supply in these different segments
of the overall labor market and by changes in the composition of the aggregate
labor force.
Several major changes in recent decades have affected labor supply and
demand. Perhaps the biggest changes have been on the supply side, associated
with the baby boom generation and the entry of increasing numbers of women
into the workforce. New entrants to the labor force typically experience
high unemployment rates as they search for jobs, change jobs frequently,
and shift between school and other non-labor force activities. If the
fraction of young workers in the labor force rises, the natural rate of
unemployment rises, and this is exactly what happened during the late
1960s and early 1970s (Figure
1) as the baby-boomers entered the labor force. As the baby boomers
aged, the natural rate fell, reflecting the fact that older workers tend
to have lower natural rates of unemployment. Similarly, the increased
participation of women in the labor force initially acted to increase
the natural rate, as women historically tended to experience higher unemployment
rates than men. In the 1990s, however, male and female unemployment rates
have been more similar so that the changing gender composition of the
labor force now has little effect on the overall natural rate.
Some economists argued earlier in the 1990s that demand factors were
pushing the natural rate up. Declines in the demand for unskilled and
low-skilled workers lowered wages for these workers and appeared to increase
unemployment, at least among men. Since these changes were not associated
with the business cycle, but seemed to reflect more fundamental changes
in the skills employers were demanding, the natural rate increased.
More recently, a number of hypotheses have been put forward to explain
why the natural rate has fallen. Some of the factors cited are really
more likely to have affected the short-run NAIRU than the natural rate.
For example, one possible factor is the increased duration of unemployment;
workers experiencing long spells of unemployment may act to moderate wage
demands, lowering the rate of inflation associated with a given unemployment
rate. Another possible factor is increased worker perceptions of job insecurity,
perhaps arising from rapid technological changes, which may have acted
to moderate wage increases. Finally, increased global competition may
have allowed the U.S. to experience lower unemployment without inflation
rising.
The role of the natural rate and NAIRU
in policy
Currently, the total civilian unemployment rate in the U.S. stands at
4.5%, the lowest level in 25 years. Almost all commentators believe this
is below the level of the natural rate. But is it below the short-run
NAIRU? If it is, the U.S. should be facing growing inflationary pressures.
Yet there is a real debate as to whether inflationary risks are present.
Does this mean the natural rate and the NAIRU are not useful concepts?
Economists are divided on this question.
As the terms have been used here, the natural rate evolves over time
in response to fundamental shifts in labor demand and supply. It represents
the economy's sustainable unemployment rate when wages and prices have
had sufficient time to adjust to demand and supply pressures. Its role
in monetary policy is twofold. First, it provides a reminder that the
economy's average unemployment rate does not depend on average inflation
and cannot be lowered through inflationary monetary policy. Instead, microeconomic
policies directed at the labor market, not policies that affect overall
aggregate spending, are the appropriate tools for affecting the natural
rate. Second, it serves as the appropriate benchmark if stabilization
objectives are a goal of monetary policy. Monetary policy cannot stabilize
unemployment around any arbitrary level, but it may help reduce fluctuations
of unemployment around the natural rate.
The short-run NAIRU can play a more direct role in the conduct of policy.
If the NAIRU helps forecast future inflation, then it can be particularly
important in an inflation targeting policy. Unfortunately, the variability
of the short-run NAIRU makes it less suitable as a benchmark for explaining
policy actions to the public. Basing policy on something that is not directly
measured, that changes frequently, and that is difficult to estimate limits
the transparency of policy and makes it more difficult for the public
to assess monetary policy.
The NAIRU has been subject to much criticism, yet it continues to appear
in policy discussions. In part, this reflects the failure of alternative
simple guides to monetary policy. At one time, many argued that growth
rates of the monetary aggregates provided useful guides for conducting
monetary policy, but in the 1980s, the relationship between monetary aggregates,
inflation, and economic activity appeared to break down, reducing their
role in policy discussion. Until a clearly superior guide that can help
to forecast future inflation comes along, the NAIRU is likely to continue
to figure prominently in discussions of monetary policy.
Carl E. Walsh
Professor, U.C. Santa Cruz,
and Visiting Scholar, FRBSF
References
Estrella, Arturo, and Frederic S. Mishkin. 1998. "Rethinking the
Role of NAIRU in Monetary Policy: Implications of Model Formulation and
Uncertainty." NBER Working Paper No. 6518.
Judd, John. 1997. "NAIRU: Is It Useful for Monetary Policy?"
Federal Reserve Bank of San Francisco Economic
Letter
97-35 (Nov. 21).
Staiger, Douglas, James H. Stock, and Mark W. Watson. 1997. "The
NAIRU, Unemployment and Monetary Policy." Journal of Economic
Perspectives 11 (Winter) pp. 33-49.
Weiner, Stuart. 1993. "New Estimates of the Natural Rate of Unemployment."
Federal Reserve Bank of Kansas City Economic Review (4th Quarter)
pp. 53-69.
Opinions expressed in this newsletter do not necessarily reflect
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or of the Board of Governors of the Federal Reserve System. Editorial
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