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.
Follow this link to view or download an explainer slideshow on the Nairu, ready for your classroom or office presentation.