What Is the Nairu and Why Does it Matter?
In December 2016, after a year-long pause, the Fed resumed its tightening of monetary policy. As usual, the action took the form of a quarter point increase in the target range for the federal funds rate (a key rate that banks charge on short-term loans to one another). Is still more tightening in store? Most observers think the answer is “yes,” but the Fed is leaving its options open. Its most recent projections, released immediately after its December meeting, hint at the possibility of as many as ten more quarter-point increases over the next three years—or perhaps none at all. So what will actually happen?
The wonkiest number in all of economics
What actually happens will depend , in large part, on what may be the wonkiest number in all of economics—the Nairu. Nairu stands for Non-Accelerating Inflation Rate of Unemployment—such a mouthful that no one ever says it out loud. Often, it is spelled out as an acronym, NAIRU, but increasingly, it is written as an actual word, with only the first letter capitalized. In the 1960s, Milton Friedman used the more civilized term, natural rate of unemployment. Today, many economists treat “Nairu” and “natural rate” as synonyms.
The basic idea behind the Nairu is simple. It is widely accepted that as the economy moves through the business cycle from recession to expansion to boom, shortages develop in labor and product markets that put upward pressure on prices and wages. The Nairu is supposed to capture the sweet spot—the lowest level to which the unemployment rate can safely fall before inflation starts to accelerate.
The Nairu is a natural fit with the Fed’s statutory objectives for the conduct of monetary policy. Under its so-called dual mandate, the Fed is supposed to aim for “maximum employment and stable prices.” The Nairu captures both parts of the dual mandate, being the maximum employment (or minimum unemployment) that is consistent with prices that are stable in the sense that the inflation rate does not accelerate from month to month.
In order actually to implement its dual mandate, the Fed needs to fill in some numbers. In recent years, it has maintained an inflation target of 2 percent per year, as measured by the personal consumption expenditure (PCE) index published quarterly by the Bureau of Economic Analysis. Putting a number on the Nairu, however, has posed more of a challenge.
Why the Nairu is so hard to pin down
Back in the 1960s, things seemed simpler. Consider the following chart, which shows the pattern of unemployment and inflation that prevailed during the Kennedy-Johnson years, 1960-1969:
The points in this chart fit closely around a trendline that economists call a Phillips curve—a curve that shows an inverse relationship between inflation and unemployment over the course of the business cycle. Taken literally, the value of the Nairu would be 6.7 percent, the level at which inflation started to accelerate after reaching its low of 0.6 percent in the fourth quarter of 1961. If, instead, we interpret the Nairu as the value of unemployment beyond which inflation begins to rise above the 2 percent target, then the chart suggests an unemployment target of about 4.3 percent.
Over the years, however, the behavior of inflation and unemployment has turned out to be far from consistent from one cycle to another. As the next chart shows, the Phillips curve shifted sharply upward in the 1970s. In more recent cycles, it is hard to find any trace of a classical negatively sloped Phillips curve. (For details, see this earlier post.)
As the once-simple pattern of the Phillips curve disappeared, economists used a variety of statistical techniques in an attempt to extract estimates of the Nairu from data on inflation, unemployment, and other indicators. The results were not been entirely satisfactory.
Part of the problem is that the estimates have not been very precise. For example, one widely cited study concluded that as of the early 1990s, there was a 95 percent probability that the Nairu would fall in the range between 5.1 and 7.7 percent—a confidence interval so wide as to make the estimate of little practical use.
More importantly, the Nairu appears to vary over time. Reasons include the changing demographics of the labor force, changes in the rate of productivity growth, and changes in policy, such as the introduction of extended unemployment benefits during recessions. The next chart shows estimates by the Congressional Budget Office of variations over time in the Nairu (or natural rate of unemployment, as the CBO still prefers to call it).
Of course, the CBO estimates are not the last word. Other estimates differ in some details but agree on the general pattern of an increase in the Nairu at the end of the 1970s, a long decline through the end of the century, and a smaller increase more recently during the Great Recession. (For a full discussion of estimation problems, see Ball and Mankiw, “The NAIRU in Theory and Practice.”)
A case in point: The December 2016 decision
The Fed’s decision to tighten policy in December 2016 illustrates the importance of the Nairu. At the time, individual members of the FOMC proposed estimates of the Nairu ranging from 4.5 percent to 5 percent, with a mean value of 4.8 percent. Here is a bullseye diagram that I used at the time to show situation they faced. The dual mandate is represented by crosshairs centered on a Nairu of 4.8 percent and an inflation target of 2 percent. (All data shown in the chart are quarterly, except for the last point, which shows the latest, still-incomplete data for the fourth quarter of 2016—unemployment of 4.6 percent for November 2016 and PCE inflation of 1.5 percent for October.)
The chart shows rising inflation and an unemployment rate that has dropped below the Nairu for the first time since the beginning of the Great Recession. In fact, the economy’s track over the last year and a half looks more like a nascent Phillips curve than anything we have seen for decades. Given the time lag before monetary policy actually affects the economy, that was enough to persuade the Fed to resume tightening.
So keep your eye on the Nairu. Yes, it’s wonky, but it matters.
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3 Responses to “What Is the Nairu and Why Does it Matter?”
Not sure why I bother. Dolan doesn't seem to publish comments any more.
The relationship between employment levels and inflation pressures has fundamentally changed. In the middle of the last century, employment was a closed system of demand for labor and labor supply. That began to change as American companies aggressively tapped labor supply in extranational low labor rate venues. And this certainly isn't limited to semi-skilled labor. Your X-rays may be read by a physician in Chennai and your taxes prepared by an accountant in Mumbai. Further, labor rate participation is lower than it has been in nearly 40 years, a time when many fewer women were in the labor force.
"So keep your eye on the Nairu. Yes, it’s wonky, but it matters"
Perhaps it matters less today than Dr. Dolan thinks.
I take your point, but I do believe the Nairu still "matters" in the sense that the Fed thinks it matters. The "bullseye" chart is the smoking gun. It is not coincidence that the resumption of tightening coincided exactly with the drop of unemployment below the FOMC median Nairu estimate. However, I agree, I would not be surprised to see the tidy-looking six-quarter "Phillips curve" in that diagram dissolve into muddle as in more recent cycles.
BTW, do please continue to comment. I am sorry that there was a delay in publishing your "jams" comment, but it has been approved for a couple of days now. I do not personally have complete control over comment moderation. I do not understand why today's comment was automatically approved, whereas the jams comment was queued for moderation, but I do my best and value your contributions. That goes for anyone. If you think I am falling behind in my moderation duties, please use the "contact" link on my blog ( http://tiny.cc/l69xbx ) to send me a personal message.
I would agree. Nairu matters. I just doubt that it matters as much as it once did or perhaps in the way that it once did. Look again at the target chart and recall some of your earlier columns using that very same chart. I recall you puzzling over the difficulty that the Fed faced using traditional monetary policy to hit the bullseye. I wonder if the current situation is primarily a response to changes in unemployment or something more like a natural reversion to normalcy.
Pardon my petulance above. It is the vanity of someone who loves the the sound of his own voice almost as much as having his misconceptions demolished. I thank you for smashing a few along the way.