Are We Near Full Employment?

Today’s news of increased layoffs raises the question of why the Federal Reserve is allowing short-term interest rates to rise. David Altig and Mark Thoma offer the explanation that perhaps the Federal Reserve believes we are near full employment so that if the Federal Reserve allows aggregate demand growth to outstrip the increase in potential output, inflation will accelerate. Max Sawicky is not happy with the current tightening of monetary policy and offered these questions:

1. How big is the output gap?
2. What is the minimum acceptable or safe rate of unemployment?
3. What is the maximum acceptable or safe employment to population ratio?

David replied:

Mechanically, that’s an easy one to answer. The estimated Taylor rule in the pictures from my earlier posts used an output-gap measure based on the Congressional Budget Office’s estimates of potential GDP. The current gap derived from this calculation is just a bit over 1 percent (where the gap is measured as potential GDP less actual GDP) … For my money, this is an upper bound on reasonable estimates of the output gap. I say it is an upper bound because this way of calculating an output gap is, in fact, pretty old-fashioned. In particular, it is not obvious that the CBO measure of potential conforms to our current understanding of how potential GDP ought to be measured.

Since David did not answer Max’s third question, let me begin by graphing the employment to population ratio from January 1996 to May 2005 as well as the capacity utilization rate over the same period.

David’s premise that the output gap is less than 1% is consistent with a target for the employment to population ratio near 63% and a target capacity utilization rate of 80%. Yet, the late 1990’s often saw an employment to population ratio equal to or greater than 64% and a capacity utilization rate equal to or greater than 82%. Even if one concedes that real business cycle events would lead one to believe that full employment should be defined in terms of somewhat lower levels for the employment to population ratio and the capacity utilization rate, I find it hard to believe that we are close to full employment.

In fact, the following graph of the output gap using the CBO estimate of potential output should illustrate my contention that the CBO measure is very conservative. For example, the late 1960’s may have been a period of excess demand but the estimate that we were 6% beyond potential seems incredulous as does the suggestion that we were beyond full employment for the entire second half of the 1990’s. Similarly, the estimated gaps for 1982 and the recent recession seem to be very low.

In a way, this debate is similar to the one between Mark and Chris Farrell where Chris is concerned that not allowing the economy to run “hot” will deter investment demand – especially investment in R&D. If Chris is saying that it is a mistake to run contractionary aggregate demand policies when the economy is below full employment, his left-leaning Keynesian position has merit. While “hot” is an ambiguous term, some economists would note that NAIRU and full employment may have different meanings. Let’s recall that there was a heated debate over monetary policy as Paul Volcker took reign over the Federal Reserve and some economists (including me) thought his monetary restraint during the latter part of the Carter Administration was a mistake.

Update: AB reader Spencer offers an important counterpoint to David Altig’s discussion of real shocks. While David may be correct in his suggestion that real shocks may have reduced potential output relative to the way the CBO determines its estimate, the real shocks of the late 1990’s were favorable. Spencer notes that the CBO estimation procedure may have missed these positive real shocks.

Update II: With many thanks to Mark Thoma, this August 2001 document explains how the CBO estimates potential output.