Welcome back, NAIRU

The drop in the unemployment rate to just below 9% is, to some, a danger sign! The funniest comment I could find on the employment report released yesterday was this piece from the WSJ. The opening paragraph says it all:

The startlingly quick pace with which the unemployment rate has fallen is raising questions whether the labor market could soon reach levels that may start to generate inflation and alter the monetary policy outlook.

The NAIRU concept – a Phillips Curve offshoot – which indicates the rate of unemployment below which inflation takes off every once in a while comes back to haunt us. In the early 1990´s it was “common knowledge” that the NAIRU was in the 6%-6.5% range. When unemployment fell below 6% in 1994 (and inflation kept going down) it was revised to 5.5%. But the unemployment rate kept falling (reaching 3.8% in early 2000) and inflation didn´t rise. At that point the more perceptive analyst just gave up on the concept.

But it´s back in full force. From Merrill Lynch, quoted in the WSJ, we read that:

Bank of America Merrill Lynch chief economist Ethan Harris notes the drop in the unemployment rate seen over the last three months is the largest since the 1950s. “This is completely off the charts,” and “I just don’t think we can continue to drop this fast,” Harris said.

So let´s check what went on in the 1950´s. Figures 1 & 2 show periods in the 1950´s when unemployment dropped fast in a short period of time. It should be noted that these instances were associated with falls in labor force participation.

Figure 3 shows the same pattern for the present time.

Figure 4 shows that following the drop in labor force participation and the strong fall in unemployment in the last months of 1954, labor force participation went back up in the next several months and unemployment kept trending down.

And what happened to inflation over the whole period that unemployment was falling? As shown in figure 5 it remained inside negative territory!

Figure 6 shows that the level of unemployment is closely linked to the “distance” of nominal spending to its trend path in the 1950´s.

Figure 7 shows that the same pattern holds in more recent times.

In short, unemployment will fall, even if labor force participation goes up, if prospects for the economy improve. For that to happen (and persist) nominal spending has to converge to a “reasonable” trend path. Inflation should go up, converging to its “desired” level. But it´s nonsense to say, as emphasized in the WSJ piece, that the fall in unemployment is an indication that the Fed could tighten earlier than expected because of the many times discredited notion regarding a minimum level of unemployment below which inflation will take off.

Note: The NAIRU concept was “invented” in 1975 by Modigliani to help him convince the Fed that it could be expansionary because unemployment could fall quite a bit before it would increase inflation. We know what happened. Unemployment went up and so did inflation!

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