NAIRU: An Awkward but Important Acronym!

With an election mere days away, today’s release of the non-farm payrolls number and the broader unemployment rate takes on added significance.  Understandably, most people will pay attention to the headline numbers and the overall trend.  There’s a concept, however, underlying the general employment figures both here and abroad that’s not broadly recognized or understood by the broader public.  NAIRU, the “Non-Accelerating Inflation Rate of Unemployment,” in basic terms is the level of “full employment.”  Government economists, academics, private sector economists, asset managers, and policymakers have spent a significant amount of time trying to understand true NAIRU levels in countries around the world.  Estimation of this metric is difficult, but important; the estimate of NAIRU could have serious implications, for instance, when it comes to the future path of monetary policy and could influence how policymakers approach unemployment issues in developed countries.  

Why is the estimated level of full employment important for monetary and fiscal policy authorities?  First, for monetary policy authorities at the Federal Reserve and ECB, for instance, NAIRU helps determine how much room policymakers have in terms of monetary accommodation before prices start heating up.  Labor remains the biggest cost for many companies.  In macro terms, when general unemployment is higher than NAIRU, labor cost pressures should be relatively non-existent, i.e. deflationary or disinflationary.  Simplistically, there’s an excess supply of labor.  On the contrary, general unemployment under the NAIRU rate leads to inflationary pressures.  Labor markets are deemed “tight.”  If NAIRU is estimated as being relatively high, and the gap between NAIRU and the unemployment rate is low, e.g. NAIRU falls at the 6% unemployment rate instead of the 4% unemployment rate, monetary authorities have less wiggle room to use expansionary policy. Alternately, a low NAIRU and big unemployment gap means that the authorities can (and probably should) use the big monetary guns to drive economic growth and drive labor markets back towards full employment.  When Ben Bernanke talks about using QE until labor markets improve to a satisfactory level, Bernanke and the Fed governors have NAIRU in mind.  For fiscal authorities and policymakers, understanding NAIRU is important because once an estimate is determined, it’s important to know what factors are causing a relatively high or low NAIRU so they can address the situation appropriately and create the correct policies to deal with the labor market situation.

Speaking of, what factors drive NAIRU higher or lower?  According to OECD economists, a rise in NAIRU is oftentimes tied to statistically significant increases in the ranks of the long-term unemployed, a condition we’ve witnessed in the US and many developed markets around the world.  Increases in the long-term unemployed are generally attributed to structural factors.  The OECD describes how structural factors can have an effect:

Workers who have been unemployed for some time tend to become less attractive to employers.  Not only the human capital of the unemployed diminishes over time, but also, as a result of recruitment costs, potential employees are frequently evaluated on the basis of frequency and duration of their periods of unemployment. Job search may also diminish as the unemployed lose contact with the labour market and awareness of job offers. There is indeed empirical evidence that long-term unemployed have a smaller influence on wage bargaining than the short-term unemployed (Guichard and Rusticelli, 2010, Llaudes, 2005 and Elmeskov and MacFarlan, 1993). As a result real wages do not fall sufficiently for the long-term unemployed to be “priced back” into the labour market.  Hence increases in the proportion of the long-term unemployed may push up the structural unemployment rate consistent with a stable inflation rate (i.e. the NAIRU).

Other factors, related and unrelated to the above, can influence NAIRU as well.  For instance, significant skills mismatches between the labor-force and industry (i.e. businesses across various industries demand skills that the labor force is having a hard time providing) can push NAIRU higher.  Demographic factors can affect NAIRU.  For instance, the Federal Reserve Bank of San Francisco identified that NAIRU might rise as the proportion of young workers rises as a percentage of the overall workforce.  This is salient now as the Baby Boomer generation retires en masse and younger workers begin to constitute a higher percentage of the force.

For whatever reasons, and probably because of a combination of factors listed above as well as other factors, NAIRU has risen across the developed world.  Coming back to the recent OECD research, across the OECD as a whole, NAIRU increased close to three-quarters of a percent between Q4:2007 and mid-2011.  In the US, NAIRU has increased from approximately 5.5% in 2006 to 6.1% today, based on OECD estimates.  In the UK, NAIRU has increased from approximately 5.5% in the mid-2000s to 6.8% today.  In Germany, on the other hand, NAIRU has fallen from about 8.25% in 2005 to 7.1% today.  

NAIRU: US vs Germany

Source: OECD

What are the current implications for higher NAIRUs?  In the US, it means that inflationary pressures could increase at higher levels of unemployment than we were accustomed to pre-crisis.   As of right now, there’s still a decent gap between the current unemployment rate of 7.9% and estimated NAIRU just north of 6%.  A move in unemployment towards the 6% to 6.5% level might provide an indication to the broader investing public that the Federal Reserve is prepared to move towards a more hawkish and restrictive monetary stance.  In Europe, ECB policymakers have a tricky road to navigate; employment gaps are substantial in the peripheral countries such as Spain and Greece, but narrow to nonexistent in countries such as Germany and Finland.  Hence, we’ve witnessed serious conflict in the Euro Zone over the future path of monetary policy.  Expect the bellyaching to continue.  For policymakers in general around the developed world, if we accept the OECD’s notion that higher NAIRUs are tied to higher long-term unemployed, and that high levels of long-term unemployment are tied to structural factors, then it becomes imperative to institute policies that can help bring the long-term unemployed back into the workforce.  Perhaps significant job training and similar initiatives could help.  Maybe policies shifting current unemployment benefit structures will have an effect to encourage people to reenter the workforce.  Some deeper understanding, though, of the carrots and sticks needed to get the long-term unemployed back in productive roles is required of politicians and their advisors.  Short-term lurching from problem to problem is insufficient to get these metrics moving back in the right direction.


References/Sources:

Guichard, S. and E. Rusticelli (2011), “Reassessing the NAIRUs after the Crisis”, OECD Economics Department Working Papers, No. 918, OECD Publishing. http://dx.doi.org/10.1787/5kg0kp712f6l-en

Walsh, Carl E. (1998), “The Natural Rate, NAIRU, and Monetary Policy”, FRBSF Economic Letter, 98-28, Federal Reserve Bank of San Francisco.  http://www.frbsf.org/econrsrch/wklyltr/wklyltr98/el98-28.html