Title: The Natural Rate and Inflationary Pressures
Abstract: The natural rate of unemployment has become an important topic recently as the Federal Reserve has raised short-term interest rates in an attempt to keep the economy from overheating. The inflation outlook for the latter part of this year and next depends critically on how close the economy is to reaching capacity constraints. The natural rate of unemployment measures capacity constraints in labor markets. BACKGROUND The natural rate of unemployment is a key concept in monetary economics. It represents the lowest possible unemployment rate that is consistent with stable inflation. When the demand for workers is so strong that the actual unemployment rate falls below the natural rate, wage and price pressures intensify and inflation starts to rise. The natural rate of unemployment cannot be observed but must be estimated. Chart 1 presents estimates of the natural rate for the years 1961 through 1994. (Chart 1 omitted) To produce this series, a statistical technique was used that links inflation movements to unemployment movements. Also shown in the chart is the actual unemployment rate. In looking at the chart, three features stand out. First, the actual unemployment rate has rarely equaled the natural unemployment rate. Second, the natural rate has remained at a relatively high level throughout the period. And third, after rising in the 1970s, the natural rate has drifted down a bit in the 1980s and 1990s. The divergence of the actual and natural rates of unemployment is a reflection of the business cycle. In the chart, periods when the actual unemployment rate exceeds the natural unemployment rate are periods of recession or the early stages of recovery. Periods when the actual rate is below the natural rate are periods of a booming economy. The relatively high level of the natural rate reflects imperfections in labor markets, imperfections that exist regardless of the overall state of the economy. Individuals unemployed at the natural rate may be unemployed for a variety of reasons. They may have the wrong skills, live in the wrong areas, or have little incentive to accept the jobs they are offered. Or, in an environment of expanding employer mandates, they may simply be too expensive for employers to hire. Whatever its many sources, unemployment at the natural rate is independent of cyclical factors and hence falls outside the domain of monetary policy. The third feature that stands out in the chart, the change in the natural rate over time, reflects both demographic and structural forces. The natural rate rose in the 1970s in part because of the growing share of women and youths in the labor force. Because women and youths typically have higher unemployment rates than men, the overall unemployment rate consistent with stable inflation rose. Also contributing to the rise in the natural rate in the 1970s were the two oil shocks and the productivity decline, all of which increased the cost of labor to employers. Since 1980, the natural rate has drifted down a bit on favorable demographic trends, the principal one being the sharp decline in the share of youths in the labor force. At the same time, however, structural forces have kept the natural rate high. These include the shift from manufacturing jobs to service jobs, the growing gap between high-tech job requirements and low-tech worker skills, and the downsizing and restructuring of firms throughout the economy. Thus, according to the estimates reported in the chart, the natural rate of unemployment is currently 6-1/4 percent. With the actual unemployment rate averaging 6.2 percent in the second quarter, this means that labor markets currently are operating at full capacity. IMPLICATIONS Historically, the gap between the actual unemployment rate and the natural unemployment rate has been a reliable indicator of future increases in inflation. This can be seen in Chart 2. (Chart 2 omitted) The shaded areas represent periods of sustained rises in inflation, with beginning and ending inflation rates noted along the top edge. …
Publication Year: 1994
Publication Date: 1994-07-01
Language: en
Type: article
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Cited By Count: 8
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