|BUSINESSWEEK ONLINE : NOVEMBER 1, 1999 ISSUE|
When Is the Jobless Rate Too Low?
Labor markets aren't tight enough to send prices soaring
Inflation bugs weren't calmed Oct. 19 by a Labor Dept. report showing that consumer prices outside of food and energy rose just 0.3% in September. They worry that labor markets are too tight, wages will shoot up, and inflation will come to a boil. They note that the unemployment rate this year is averaging 4.3%--far below the 6% or so that was long considered the ''natural rate of unemployment,'' below which inflation would take off. With the job market this tight, says Ken Matheny, senior economist at Macroeconomic Advisers, a St. Louis-based consulting firm, ''You run the risk that two to three years from now, you'll have higher inflation, higher unemployment, and higher interest rates. It's a slippery, somewhat dangerous slope.''
But there may be less cause for jitters than meets the eye. Several top labor economists are now saying that the so-called natural rate of unemployment has probably fallen to 5% or below--which would put it only a little higher than today's actual jobless rate. If so, that means that a fairly modest cooling of the economy would be all that's required to remove the labor-force pressure on inflation.
Other economists go further, arguing that the natural rate is so changeable and hard to pin down that it's useless for forecasting inflation. ''No one but God knows what the natural rate is,'' says Harvard University economist James L. Medoff. His advice to the Federal Reserve: Wait to see actual evidence of inflation before ''messing around with interest rates.''
Even economists who do see some use for the natural-rate concept nonetheless say that changes in the structure of the labor force make it somewhat unstable. Allan B. Krueger of Princeton University and Lawrence F. Katz of Harvard, in a Brookings Institution paper this year, cited four factors that they estimate have reduced the natural rate by about one percentage point since the mid-1980s. Accounting for about 0.4 percentage points is the aging of the population; older people tend to be more fully employed. The growth of temporary staffing firms, which rapidly match job-seekers with employers, accounts for about 0.2 to 0.4 percentage points. The doubling of the prison population accounts for up to 0.2 percentage points, by removing from the labor force people who are less likely to be employed. Worker insecurity might account for another 0.1 percentage points, says Katz. So what's his take on the natural rate? ''With a very large amount of uncertainty,'' he says, ''I would think it's in the high 4's.''
NATURAL RATE. The concept of a natural rate of unemployment is only about 30 years old. Before then, in 1958, a New Zealander economist named A.W. Phillips had argued that there was a long-term trade-off between inflation and unemployment. But in 1968, Milton Friedman of the University of Chicago and Edmund S. Phelps of Columbia University attacked the idea of a Phillips Curve trade-off, calling it strictly temporary. The government can't suppress unemployment for very long by accepting higher inflation, they said. Workers will catch on that higher inflation is eroding their wages and demand raises, which will cut corporate profits, slow the economy, and drive unemployment back up to its natural level. NAIRU, which stands for ''non-accelerating-inflation rate of unemployment,'' means the same thing but avoids the value-laden word ''natural.''
In trying to measure the natural rate, economists look at what actually happens to inflation at various levels of unemployment, trying to weed out complicating factors such as big changes in oil prices. Using that method, James H. Stock and Douglas O. Staiger of Harvard and Mark W. Watson of Princeton have calculated that the natural rate of unemployment was about 5.3% in the mid-1960s, then rose to around 6.5% through the 1970s and 1980s, before beginning a gradual decline to about 5.1% by early 1996.
It's impossible to know what today's natural rate is, says Stock, because the current level of unemployment won't work its way through to the consumer price level for at least a year or two: ''How would you ever know we're below the NAIRU? The only way you'll ever know that is by waiting a couple of years.''
OTHER INDICATORS. That uncertainty is why NAIRU is not the most useful idea for policymakers at the Federal Reserve. Donald L. Kohn, director of the Fed's Div. of Monetary Affairs, said at a National Bureau of Economic Research conference last year that NAIRU is only one input among many in the Fed's forecast of inflation. Stock, Staiger, and Watson maintain that it is less accurate as a predictor of inflation than such other widely followed measures as the factory capacity utilization rate, the level of initial claims for unemployment insurance benefits, and housing starts.
To be sure, there are still some prominent economists, such as Robert J. Gordon of Northwestern University, who believe that the natural rate of unemployment remains at 5.5%, once special factors such as energy prices are screened out. Macroeconomic Advisers uses 5.5% as its NAIRU estimate. Its inflation measure is compensation per hour, rather than the Consumer Price Index, and Matheny says that ''our forecast of wage compensation has done very well.''
But most economists believe that the natural rate of unemployment has fallen significantly. And though it's probably not as low as the current jobless rate, it's most likely close enough that the U.S. economy isn't teetering on the edge of an inflation disaster.
By Peter Coy in New York
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When Is the Jobless Rate Too Low?
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