In Search of the Ideal Jobless Rate

America may have a new Nairu. Developed by the late economist Milton Friedman, Nairu is the unemployment equivalent of Goldilocks' perfect bowl of porridge—a jobless rate that's not so high it triggers deflation or so low it sets off galloping inflation.

Nairu stands for nonaccelerating inflation rate of unemployment. Every economy has one. Sometimes it is referred to as the natural rate of unemployment. The factors that influence a country's natural rate of unemployment are many: The bargaining power of unions, the productivity of the workforce, the presence of minimum wage laws, and the willingness of workers to relocate are just a few of them. Europe's Nairu has traditionally been around 8 percent, says Johns Hopkins University economist Laurence Ball. Economists estimate that the U.S. has had a natural rate of unemployment of 5 percent since the mid-1990s. That relatively low level has given the Federal Reserve room to maneuver in setting interest rates.

Now many economists, including Dean Maki at Barclays Capital (BCS), 2006 Nobel Prize winner Edmund Phelps, and Bank of America Merrill Lynch's (BAC) Ethan Harris, think the financial crisis has pushed the U.S.'s natural rate of unemployment to between 6.3 and 7.5 percent. It may seem odd to worry about such things, with the jobless rate stuck above 9 percent and the economy flirting with deflation. Yet the stakes are high.

As Barclays' Maki explains it, the U.S. labor market is tighter than it appears. Many jobless were trained for work that has been wiped out. Some of these unemployed aren't qualified for the highly skilled jobs that often go begging. When employers do find the right candidates, they have to pay them competitively. Other factors restrict the labor pool further. People whose homes are worth less than their mortgages are reluctant to move for work. Extended unemployment benefits deter some people from accepting jobs.

If Maki and other economists are right, then the Fed could damage the economy by keeping rates low for too long. In this scenario, loose monetary policy lasts until the jobless rate slips beneath the new natural rate of 7 percent, and inflation breaks out. "You could be sitting at a zero-percent fed funds rate at full employment and not realize it," says Maki.

That's what happened in the 1970s as Maki tells it. The Fed thought the natural rate of unemployment was 4 percent and kept borrowing costs low in hopes of reaching that target. That led to double-digit price increases. Policymakers ended up raising their benchmark rate to 20 percent in the early 1980s, at tremendous cost to the economy. The natural rate, it turns out, was more like 7 percent, according to Maki.

A higher natural jobless rate would be a drag on the budget deficit, because the government would collect less tax revenue from the employed while spending more on jobless benefits. The Fed is not sounding the alarm about Nairu. Yet in the minutes of the latest Federal Open Market Committee meeting on Apr. 27-28, two participants estimated that longer-run unemployment would settle in at 6 to 6.3 percent, barring any more big shocks to the economy. Longer-run unemployment is considered a proxy for Nairu. A year earlier, none of the participants projected a longer-run rate higher than 5.3 percent.

The bottom line: The natural rate of unemployment may have drifted up to 7 percent. If so, that makes the Fed's timing on tightening much trickier.

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