Neal Soss and Henry Mo at Credit Suisse published a very interesting article, “Where is full employment in a more volatile macroeconomy?”, where they argue that the natural (long run) rate of unemployment may be shifting (they do this by showing that the Beveridge curve, which plots the the job vacancy rate against the unemployment rate, is shifting upward). I cannot provide a link, but here are their conclusions pertaining to monetary policy:
In the case of rising NAIRU [RW: this is the rate of unemployment that does not grow inflation, often called the long-run rate] and higher economic volatility, the monetary policy implication is complicated.
On the one hand, a higher NAIRU suggests that it would require a strong and prolonged recovery for the unemployment rate to return to the level attained in the past two decades. This scenario argues for a long period of low interest rates, because the economy’s structure will make it harder to get unemployment back to the low levels of recent business expansions.
On the other hand, a higher NAIRU suggests higher inflation pressure, as the output gap is smaller than otherwise would be the case. In other words, the Fed would have to normalize its policy stance sooner than would have been the case warranted by a stable NAIRU.
The burden of this is likely to be several years of quite low short-term interest rates by any modern standard other than the zero-ish levels of today. Even if the NAIRU is deteriorating, it is likely to be several years before the economy generates enough of a drop in unemployment to get to the new NAIRU, presumably above the levels of the last 20 years but surely below the current 9.7% unemployment rate. Between now and then, high unemployment is likely to remain the focus of policy attention. Labor market policies, such as job retraining for the unemployed, to improve the inflation unemployment trade-off, would make the central bank’s job a lot easier as that longer-run unfolds.
Basically, if the long-run level of unemployment, which the Fed targets implicitly under their dual mandate (maximum sustainable employment and stable prices), is changing then the Fed’s job becomes that much more difficult. Policy is only as good as the model’s calibration: they need to confidently estimate and target a level of employment that may be very much in flux. A simple Taylor Rule estimation illustrates this point.
Note: The Taylor Rule is a policy rule that relates the federal funds target to inflation and the output gap: roughly speaking, as inflation rises relative to the output gap, the Fed should tighten (raise its target); and as the output gap rises relative to inflation, then Fed should ease (lower its target). I estimate the relationship, and you can view my data here, and Wells Fargo’s forecast here.
On one hand, the CBO projects that NAIRU is 4.8%. In this case, the Taylor Rule policy drops the fed funds target to -4.6% by the end of the year. Put it this way: the output gap is so big that policy is very, very aggressive but bound by zero.
On the other hand, if NAIRU has shifted to something more like 6% – this is roughly its level in the 1980’s – then the policy prescription is less aggressive. The output gap remains wide, but the implied target rises to -3% rather than almost -5% – still negative, but suggestive of a more benign policy strategy. Inflation pressures would start to build earlier than under the 4.8% case.
This complexity has been documented by the Fed in the minutes of their August 2009 meeting:
Though recent data indicated that the pace at which employment was declining had slowed appreciably, job losses remained sizable. Moreover, long-term unemployment and permanent separations continued to rise, suggesting possible problems of skill loss and a need for labor reallocation that could slow recovery in employment as the economy begins to expand.
Note: this not the same thing as a jobless recovery – the unemployment rate may very well fall with economic growth (no jobless recovery), but then settle at a structurally higher level.
P.S. I will not be able to respond to comments until tomorrow.