A Changing Natural Rate of Unemployment: Policy Issues
Released: 2006-07-10T00:00:00

Introduction

Decisions to tighten or ease fiscal or monetary policy rely heavily on the economy's positionrelative to a concept of "full employment," or how much of the economy's labor and capital resourcesare employed compared to potential resources. Central to determining full employment is theconcept of a natural rate of unemployment. When actual unemployment is below (above) the naturalrate, it suggests that the economy is operating above (below) full employment and policy should betightened (eased) to prevent inflation from accelerating (decelerating). Thus, a reliable estimate ofthe natural rate plays an important role in macroeconomic stabilization policy decisions. This reportdiscusses problems in estimating the natural rate.

The Natural Rate Concept

In the 1960s, economists Milton Friedman and Edmund Phelps independently developed theconcept of a "natural rate" of unemployment or "full employment" rate of unemployment or NAIRU(non-accelerating inflation rate of unemployment.) (1) They posited that there was an equilibrium, market-clearing rateof unemployment determined by labor market characteristics, policy, and conditions. This naturalrate will be greater than zero since, at any given point of time, there will always be some people inthe process of moving from one job to another, and some people who are in the wrong place at thewrong time for the jobs available.

Although expansionary fiscal or monetary policy may be able to temporarily pushunemployment below the natural rate in exchange for higher inflation, eventually actualunemployment would rise back to the natural rate without inflation falling. This concept isconsistent with the view that monetary policy has no long-run effect on real variables such aseconomic growth or unemployment, and affects only prices in the long run. If unemployment didnot return to a natural rate, it would imply that monetary policy could permanently affectunemployment, and workers suffered from "money illusion" (their wage demands were influencedby nominal instead of real price changes). (2)

In recessions or periods of sluggish growth, unemployment rises above the natural rate andinflation is expected to fall. Thus, estimating the natural rate requires stripping out cyclical factors,including both the increase in unemployment that occurs in recessions and the decrease that occurswhen the economy has been temporarily pushed beyond full employment.

A Changing Natural Rate?

A cursory look at the U.S. experience over the past 55 years seems to belie the existence ofa natural rate of unemployment, as seen in Table 1 . Over long periods of time, business cycle effectsshould cancel out and the average unemployment rate should be close to the natural rate. Yet theaverage unemployment rate by decade has varied significantly, ranging from a low of 4.5% in the1950s to a high of 7.3% in the 1980s. Regressions for the period 1960-2000 yield a constant naturalrate of unemployment of 6.1%, which seems unrealistically high for both the 1990s and the1950s-1960s. (3) Inparticular, the experience in the late 1970s (rising inflation although unemployment was abovenatural rate estimates) and the late 1990s (falling inflation although unemployment was belownatural rate estimates) seem at odds with the natural rate concept.

Table 1. Annual Unemployment Rates,1950-2005

(percent)

Source: Bureau of Labor Statistics

Skeptics take the variance in actual unemployment over time as evidence that the natural rateconcept is incorrect. But mainstream economy theory suggests a more subtle view -- that there isa natural rate, but it varies over time. The natural rate is determined by labor market conditions;economists reason that since labor market conditions change over time, so could the naturalrate. (4) If this were thecase, the unemployment rate would always return to the natural rate, as the original theory suggests,but at any given point in time, unemployment would be reverting to a unique natural rate. Forexample, a natural rate concept underlies the Congressional Budget Office's economic projections,and a new natural rate estimate is calculated each year. CBO's changing estimate of the natural rateis plotted in Figure 1 . The figure illustrates that even with a changing natural rate estimate, actualunemployment is still rarely equal to the natural rate.

Figure 1. Actual Unemployment and CBO's Estimate of the Natural Rate,1950-2002

Source: Congressional Budget Office

Potential Causes of a Falling Natural Rate in the 1990s

From the mainstream perspective, the 1970s and 1980s were a period of a rising natural rate,and the 1990s were a period of a falling natural rate. The 1990s decline caught most economists bysurprise. (5) What couldhave caused the natural rate to fall in the 1990s? A number of theories have been advanced: (6)

High Productivity Growth

"Unit labor costs" is a measurement that compares the value of output to the cost of laborinput. By definition, whenever productivity increases more rapidly than wages, unit labor costs fall. Lower unit labor costs increase the firm's profitability, thereby typically increasing the firm's demandfor labor. In the late 1990s, there was a sudden and unexpected rise in the labor productivity growthrate, from 1.4% in 1974-1995 to 2.5% in 1996-2000. It has been hypothesized that because workerscannot easily or instantaneously identify changes in their productivity, they may have been slow toadjust their wage demands to reflect higher productivity growth rates. If this was the case,unemployment and the natural rate would have temporarily fallen in the late 1990s as unit labor costsfell. A similar story can be told about long-term wage contracts, under which wages would notadjust to the change in productivity until a new contract was negotiated. Notice that this decline inthe NAIRU would only be temporary: once workers became aware of the increase in theirproductivity growth rates, other things being equal, they would adjust their wage demands and unitlabor costs would rise back to an equilibrium level, removing the incentive for firms to take on moreworkers. (7)

If this scenario occurred in the late 1990s, labor productivity should have grown more rapidlythan real worker compensation. As can be seen in Figure 2 , this has been the case. In only two ofthe past 13 years, 1998 and 2000, has real compensation grown more quickly than productivity,suggesting that workers did not fully incorporate actual productivity growth into their compensationdemands in the short term. Compensation has still not caught up to more rapid productivity gainsthat began several years ago.

Also supportive of this theory is the experience of the 1970s and 1980s. Just as increasesin productivity growth may temporarily reduce the NAIRU, decreases in productivity growth maytemporarily increase the NAIRU. And indeed, the apparent increase in the natural rate in the 1970sand 1980s coincided with a slowdown in productivity growth. From 1949 to 1973, laborproductivity grew at an average of 2.9% a year; it then slowed to an average of 1.4% from 1974 to1995. The unemployment rate at the trough of the 1973-1975 recession was higher than the past,and it remained higher relative to comparable points in past business cycles during the next twoexpansions and recoveries.

This theory does not seem consistent with the experience during the 2001 recession andsubsequent "jobless recovery," however. (8) In this period, productivity growth also rose unexpectedly rapidly,yet employment fell for 20 months after the recession had ended, and fell 2.6 million from peak totrough. This occurred even though productivity has continued to grow more rapidly than realcompensation since 2001. It seems that several years after the productivity spurt had first begun,workers had still not completely adjusted their wage demands to take the productivity spurt intoaccount. The comparison is not straightforward, however, because weakness in the labor marketsince 2001 has held down compensation growth. Since mid-2003, employment has begun to riseagain, but real compensation growth is still relatively modest, despite continued rapid gains inproductivity.

Figure 2. Labor Productivity and Real Worker Compensation

Source: Bureau of Labor Statistics

Note: Data are for non-farm business sector.

Labor Market Policy Changes Some policymakers point to changes in labor market policy in the1990s as a potential cause of the decline in the NAIRU. For example, if welfare reform increasedthe incentives to seek work, it could have expanded the pool of labor available to employers andlowered the unemployment rate consistent with stable inflation. (9)

Whether or not policy changes have affected the NAIRU, it would be difficult to measure therelationship empirically. Policy changes cannot be easily quantified and are not conducive toeconometric analysis. Time series analysis is problematic because a one-time policy change givesthe statistician only one data observation, while cross-section analysis is difficult because theindividuals affected by the policy change are likely to be systematically different from the rest of thepopulation in ways that cannot be easily controlled for. Therefore, it is difficult to say with anydegree of confidence that evidence exists proving or denying the hypothesis that policy changes havehad a significant influence on the natural rate. (10)

Demographic Changes

It has been noted that younger workers consistently have higher unemployment rates thanolder workers. This could be because older workers have more experience, more "human capital,"and different preferences for employment stability. This suggests that demographic shifts toward anolder workforce could lower the overall unemployment rate since the proportion of older,low-unemployment workers in the labor force is greater. There is some evidence of this, as the babyboomers were young workers in the high natural rate decades of the 1970s and 1980s, but have nowreached a low unemployment age. The percentage of workers 16-24 years of age, the group with thehighest unemployment rate, had fallen from 25% in 1978 to about 16% in 2000. (11) Economist Robert Murphyrecalculated the 1998 unemployment rate based on a population demographically similar to the 1979population. This raised the unemployment rate by 0.6 percentage points -- not likely enough toaccount for the entire change in the natural rate, which may have fallen 0.5-2.0 percentage pointsover those years. (12) Katz and Krueger estimate that demographic change can account for one quarter of the decline inthe NAIRU. (13)

Higher incarceration rates are another demographic factor that could affect the natural rate. Katz and Krueger have also suggested that many young, low-skill individuals who would have beenunemployed in the past are now in prison instead and not counted as part of the labor force. Between1990 and 1999, the incarcerated population grew at an average rate of 5.7% annually, resulting ina doubling of the prison population over that time. (14) As a result, they estimate the NAIRU fell by 0.17 percentagepoints since the mid-1980s.

Rising disability claimant rates offer another explanation for why the natural rate has fallen. If the disabled are more likely to be unemployed than the rest of the population, more workersclaiming disability could push the natural rate down. The percentage of the non-elderly populationclaiming disability rose from 3.1% in 1984 to 5.3% in 2000. Autor and Duggan found that thischange explained 0.64 percentage points of the recent fall in unemployment. (15)

Unlike some other factors driving the natural rate, demographics are easily quantified andempirical correlation can be easily measured. Murphy points out that the timing of theseexplanations does not quite correspond to the fall in unemployment. The demographic shift and therising incarceration rate were both well underway in the late 1980s, before there was a noticeabledecline in the NAIRU.

Changes in Labor Market Matching

Economists often think of unemployment as part of a matching process, whereunemployment lasts until the right worker finds the right job. In this view, the duration ofunemployment depends on how quickly workers can be matched with jobs that well suit their skillsand desires. It has been suggested that recent developments in the labor market could have improvedthe matching process, thereby reducing the duration of unemployment, and in turn, the natural rateof unemployment. These factors include the expansion of temporary employment, greater regionalmobility, the expanding role of the internet in job seeking, and a generally more flexible attitudetoward job switching. (16) While these factors may play an important role in determining the natural rate, they are, to varyingdegrees, unquantifiable and therefore difficult to properly take into account in empirical estimatesof the natural rate. The most quantifiable factor, temporary employment, has been estimated to havea modest effect on the natural rate. A Federal Reserve study found that temporary unemploymentcould explain 0.28 percentage points of the fall in the NAIRU from 1979 to 1993, and Katz andKrueger estimated that it lowered the NAIRU by 0.39 percentage points in the 1990s. (17)

Back to the Future?

Unemployment rates seen in the late 1990s were similar to the average unemployment ratein the 1950s and 1960s. This suggests that the natural rate today may also be similar to thosedecades. Then-Federal Reserve Chairman Alan Greenspan made this point in a 2004 hearing:

Well, [full employment] varied over time. Rememberin the early part of the post-World War II period, the general view was that, indeed, 4% was theunemployment rate which was consistent with price stability. It then altered very significantly duringthe 1970s and the 1980s and it has since come probably almost all the way back down to where itwas in the early part of the post-World War II period. (18)

Is this a coincidence or do these eras share something in common? An older population and highproductivity growth rates suggest some commonality -- the proportion of workers age 16-24 was17% in 1960, compared with 16% in 2000. Some would argue that welfare reform was a reversalof the expansion of the social safety net that began with the Great Society programs of the late 1960s. On the other hand, other factors, such as the growing role of temporary employment and the Internetin our labor market or rising incarceration and disability rates, suggest that any similarity to the1950s and 1960s is merely coincidental.

The Jobless Recovery -- Could the Natural Rate Be Responsible?

Employment fell for an unprecedented 20 months after the 2001 recession had ended. Onepossible reason why is that the natural rate was rising during this time. During a period when thenatural rate was rising, a prolonged sluggish labor market could result regardless of the state of thebusiness cycle. But because the natural rate is a long-run concept, it is difficult to believe the naturalrate could have changed significantly over the past 2Â½ years. There has not been any major changein labor market policy during that time, and demographic changes are incremental. If the natural ratehas changed, it would be part of a longer trend that will not be identifiable in the near term.

There is another reason why the unemployment rate might have continued to rise for so longrecently related to the natural rate concept. Even if the natural rate had not changed over the past2Â½ years, it is possible that when unemployment reached 3.9% in December 2000, it was furtherbelow the natural rate than suspected. Just as the unemployment rate can temporarily rise above itsnatural rate when growth is too slow, unemployment can temporarily fall below the natural rate whengrowth is unsustainably fast. In these circumstances, one would expect to see a rising inflation rateas wages are pushed above productivity because too many jobs are chasing too few workers. Feweconomists believed the natural rate had reached as low as 3.9% in 2000, but many assumed that3.9% was not too far from the natural rate because there was no significant upward pressure oninflation at that time. In hindsight, if the natural rate has been higher than suspected in recent years,say 6.0% vs. 5.0%, then the prolonged increase in the unemployment rate over the 2Â½ years couldpartly be attributable to the long-term adjustment back towards the natural rate from an unsustainablylow level. In this case, one would expect the unemployment rate to fall once the recovery becamemore robust, but it would fall less than expected. Those who argue that the natural rate wasunderestimated in the late 1990s point to the fact that the natural rate averaged 6%-6.5% in the 1970sand 1980s. To put that figure in perspective, consider that the unemployment rate following the2001 recession would have been considered to be full employment, only attainable near the peak ofthe business cycle, 20 years ago.

Because the natural rate is a long-run concept, it is too soon to determine which portion, ifany, of the recent increase in the unemployment rate is supply-side driven, and which portion isdemand-driven. But the inflation rate is one piece of evidence to determine whether inadequatedemand or a change in the natural rate is currently driving the rise in unemployment. If the economywas suffering from insufficient demand, the inflation rate should have been falling; if theunemployment rate was being driven by changes in the labor market, inflation should be unaffected. The core inflation rate, which strips out volatile food and energy prices, fell from 2.6% in 2001 to2.4% in 2002 to 1.4% in 2003. This indicates that insufficient demand was likely to be at least partof the story behind the rise in the unemployment rate.

Since 2003, the unemployment rate has fallen to 5.1% in 2005 and below 5% in 2006. It stillhas not reached the lowest point of the 1990s expansion, however. Over the same period, inflationrose to 3.4% in 2005, while core inflation rose to 2.2%. This suggests that actual unemploymentmay be lower than the NAIRU again.

Alternative Theories

Although the natural rate (which changes over time) hypothesis is the mainstream view ineconomics, the hypothesis is not without its critics. At least four alternative explanations have beenoffered.

Phillips Curve Can Be Exploited Indefinitely

The mainstream position that monetary policy has no long-term effects on real variables, suchas unemployment, does not specify how long it takes to get to the long term. One view, whichessentially harkens back to pre-NAIRU macroeconomics, argues that the effects of monetary policyare long enough lasting that policymakers can essentially exploit the unemployment-inflationtradeoff (known as the "Phillips Curve") indefinitely. (19)

This view has a number of shortcomings. First, while it may be true that a higher and higherinflation rate could be traded off with a lower unemployment rate for long periods of time, it is notclear why this would be a desirable policy outcome (since people dislike high inflation), particularlysince larger and larger increases in inflation would be needed to achieve a given reduction inunemployment as unemployment fell. Second, it has trouble explaining the 1970s, when inflationand unemployment rose simultaneously. Third, the Phillips Curve can only be exploited indefinitelyif the inflationary expectations of individuals do not change over time. That is, it assumes thatincreases in the money supply can continually pump up the economy without individuals everlearning to predict it. Experience from abroad suggests that monetary stimulus ceases to have anyeffect on the real economy during hyperinflation because expectations do adjust.

Monetary Policy Changes Cannot Affect Unemployment If It Is Expected

Another challenge to the natural rate hypothesis comes from the opposite perspective: thatany change in monetary policy that is expected or predicted will have no effect on the economy orthe unemployment rate. Part of the "rational expectations" movement in the economics professionin the 1970s, this conclusion is reached by assuming that individuals are always rational and wellinformed, so that changes in the money supply instantly lead to changes in the inflation rate. In thisview, rising inflation would not be associated with an unemployment rate below the NAIRU (sincethe monetary change had no real effect), and falling inflation would not be associated with anunemployment rate above the NAIRU. However, the concept that the unemployment rate wouldalways be at the natural rate (unless unexpected monetary changes occurred) would be consistentwith this view. (20)

While this view had a revolutionary effect on academic economics, its empirical relevance-- in its purest form -- has been limited. There is overwhelming evidence that monetary changesalways have affected -- and still do affect -- real economic variables in the short run, in directcontradiction to the rational expectations theory.

Deviations from Natural Rate Caused by Inflation, Not Labor Market

The natural rate is defined in terms of a relationship between unemployment and inflation. Some economists defending the natural rate concept have argued that recent deviations from it havebeen caused by inflation-related developments rather than changes in the labor market that havecaused the natural rate to change. For example, Robert Gordon has argued that a series of temporaryfactors held the inflation rate down in the mid-1990s, including low energy, medical, computer, andcommodity prices, despite the fall in unemployment below the natural rate. (21) However, most of theseprices have risen since. Besides, the shortcoming of this argument is that there will always be someprice increases below the increase in the general price level, and some above. It is unlikely that theprices of goods that are falling will not be offset by those that are rising. As the unemployment ratestayed below the estimated NAIRU for at least four years in the late 1990s, the temporary factorsargument became less and less convincing. There was a slight increase in inflation toward the endof the last expansion, but not nearly as much as models based on a constant natural rate would havepredicted.

Others have argued that low inflation can be explained by a new unwillingness by workersto demand compensation increases because of globalization (e.g., greater foreign competition) andother factors that have made markets more competitive. This argument is hard to prove or disproveempirically, since there is no conclusive way to measure the competitiveness of markets over time. Globalization's influence on wages is thought to be limited since imports are still small relative toGDP, and have increased only gradually. (22) If globalization did reduce the relative wages of affectedworkers, it would only reduce overall inflation if it were accommodated by the Federal Reserve,which is unlikely given that one of the Fed's primary goals is price stability. In any case, the datado not support the argument throughout the period -- Figure 2 shows that compensation increaseswere small in the early 1990s, but healthy from 1998 to 2000, suggesting this factor was notimportant in the later stages of the expansion.

Hysteresis

The natural rate hypothesis suggests that because unemployment always returns to the naturalrate, recessions should have no permanent effect on unemployment (or the natural rate). This viewwas challenged by a group of economists in the 1980s, who argued that serious recessions could raisethe natural rate, meaning that the business cycle could have permanent effects onunemployment. (23) Thisview, called "hysteresis," sprung from empirical evidence, particularly in parts of Western Europe,where the natural rate seemed to jump dramatically following the deep recessions of the 1970s and1980s. (24) A numberof explanations was devised to give it theoretical underpinnings, such as the theory that sustainedperiods of unemployment (which increased in deep recessions) led to a deterioration in workers'skills that made them less employable. The empirical evidence in the United States is not as strongas Western Europe; nonetheless, it is striking that the rise in the NAIRU coincided with the twodeepest recessions (1973-1975 and 1980-1982) of the post-war period.

The hysteresis view can be seen more as a complement to the natural rate theory than analternative. With hysteresis, there is still a natural rate at any given time, and inflation will rise (fall)if unemployment is below (above) it. Hysteresis stipulates that the business cycle is another factorthat can change the natural rate. In the purest sense, however, hysteresis does contradict the naturalrate view that monetary policy (through its effect on the business cycle) has no permanent effect onthe unemployment rate.

Measuring the Natural Rate in Practice

How the natural rate is theoretically conceptualized and how it is empirically estimated arequite different. Most empirical estimates do not use the conceptual approach discussed in this report:they do not define the natural rate in terms of labor market conditions and then try to estimate howmuch each condition contributes to changes in the natural rate over time. As discussed above, onereason why this approach would not be fruitful is that many of the factors cannot be easily quantified.

One approach to estimating the natural rate, taken by CBO, for example, is based on theapproach described above of explaining changes in the inflation rate econometrically, and ignoringthe labor market factors that would change the natural rate. (25) Besides unemployment,CBO lets the inflation rate be influenced by past inflation, productivity growth, food and energyprices, and price controls (for the early 1970s). (26) The notion is that the unemployment-inflation relationship willnot hold in the presence of a supply shock, but if shocks are controlled for, a stableunemployment-inflation relationship can be identified. Unfortunately, supply shocks are not alwaysreadily identifiable, but productivity and energy prices are two obvious candidates. Changes inmonetary policy are not determinants of inflation in this equation. Using past inflation as adeterminant of current inflation implies that individuals assume inflation will be the same as in thepast, which may not be consistent with rational expectations. Similar models by other authors baseexpected inflation on survey results, instead of assuming expectations are based on the past.

CBO's model produces a constant NAIRU for married men; it then estimates an overallNAIRU which varies over time because of demographic changes. Although CBO's estimate has ahigh goodness of fit by measures like the R-squared and t-statistic, a constant NAIRU will divergefrom actual experience over short periods of time. For example, it does a poor job explaining whyinflation did not rise when unemployment was a percentage point below the CBO NAIRU estimatein the late 1990s. (27)

Gordon uses a similar estimation method and similar control variables to CBO, but allowshis estimate of the NAIRU to vary from year to year, unlike CBO's NAIRU for married men. (28) After estimating the causesof inflation, a natural rate can be backed out of the equation in any given year by holding otherfactors constant. The estimate of the natural rate varies from year to year because it includes theequation's error term. Gordon then limits how much the natural rate can vary to smooth the annualfluctuations out. It should be stressed that Gordon's NAIRU varies only because the actual data varyin ways that Gordon does not attempt to explain. The smoothness of the changes in the NAIRU isimposed by Gordon's model -- it is not derived from the data. A critic of the NAIRU concept couldargue that rather than proving that there is a varying NAIRU, Gordon has demonstrated that actualunemployment changes unexpectedly to such an extent that the NAIRU concept is not useful. (29)

Barnes and Olivei hypothesize that unemployment is only an important determinant ofinflation when unemployment is unusually high or low. They use an approach similar to CBO, withthe modification that observations where unemployment is outside of their interval of 4%-7.5% areseparated from observations within the interval. Their results show that the effect of unemploymenton inflation is much larger and statistically significant when unemployment is outside the interval. The drawback to this method is that the observations outside the interval are not randomlydistributed across the sample: they are mostly limited to the mid 1960s, mid 1970s, and early 1980s. Thus, their method still leaves unanswered the question of why the unemployment-inflation tradeoffonly broke down at certain times within the interval, notably the late 1970s and late 1990s. Anarrower band would have reduced this problem. (30)

Grant's estimate of the natural rate is fundamentally different than the other three modelsdiscussed here, because his natural rate estimate is not based on the empirical relationship betweenunemployment and inflation. This avoids the problem of controlling for inflation induced by supplyshocks, but somewhat changes the meaning of the natural rate. He first estimates output gaps bycalculating the difference between actual GDP and trend GDP, which he constructs using variousstatistical techniques. He then calculates a natural rate of unemployment by regressingunemployment on his output gap measure, and allows the natural rate to vary over time. LikeGordon, this approach can be criticized on the grounds that it does not offer any theoreticalexplanation for why the natural rate would be changing over time; it only changes because ofvariation in the actual data. Some of his results are questionable because they show the NAIRUlowest in the 1970s and highest in the 1990s. (31)

A Useful Concept for Policymaking?

The natural rate concept is often accompanied with enough qualifiers that, on the one hand,it becomes difficult to refute empirically, and on the other hand, may arguably limit its practicalvalue. The qualifiers include (1) because of business cycle fluctuations, actual unemployment willrarely if ever equal the natural rate; (2) the natural rate can change unpredictably over time; and (3)the relationship between the natural rate and inflation will not hold when other factors that alsoinfluence inflation are present. The third qualifier is more problematic than it may first appear whenone considers that the natural rate is defined in terms of its relationship to inflation. Empirically,these qualifiers mean that there is no straightforward test to compare the merits of the argument "anatural rate of unemployment does not exist" to the argument "a natural rate of unemployment exists,but because it changes unpredictably, it cannot be identified until after the fact."

The methods for estimating the NAIRU described above are essentially backward-looking. Because they by and large do not identify the fundamental labor market sources of changes in thenatural rate, they cannot predict how the NAIRU will change in the future. This was the case withthe apparent fall in the natural rate in the late 1990s, which took most economists by surprise. Thisis problematic for policymakers: it implies that at any given point, they cannot distinguish whethera movement in unemployment is caused by the business cycle (and should be counteracted withstabilization policy) or by a change in the natural rate (and should not be counteracted with policy). If the Fed had relied heavily on NAIRU estimates of the time, it could have unnecessarily tightenedmonetary policy in the 1990s, cutting short an expansion that never resulted in significantly risinginflation. Likewise, Orphanides and Williams blame much of the stagflation of the 1970s on theFed's failure to recognize the natural rate had risen, which led it to keep policy too loose. (32)

On the other hand, attempts to systematically identify changing labor market characteristicsin order to predict changes in the natural rate beforehand are likely to prove frustrating since, asdiscussed above, many of the characteristics thought to be important change infrequently (resultingin a dearth of observations for statistical analysis) and are difficult to quantify. For that reason,explanations based on this approach are open to the criticism of post hoc ergo propter hoc rationalization (deducing causation by identifying correlation after the fact), and may therefore alsofail to forecast changes in the NAIRU accurately.

Staiger, Stock, and Watson argue that while a statistically significant NAIRU can beestimated, the margin of error is too broad for the concept to be of much practical use topolicymakers. (33) Forexample, in the first quarter of 1994, they estimate a NAIRU of 5.9% using the consumer price index(CPI), with a 95% confidence interval of 3.9% to 7.6%. (34) For policymaking, their findings suggest that the Fed, forexample, could be certain that policy should tightened only when unemployment was below 3.9%(controlling for the other factors in the estimation) and eased when unemployment was above7.6%. (35) By way ofcomparison, unemployment never exceeded 6.3% in the recent recession; if the Fed had based itspolicy decisions on the criteria of statistical significance, no monetary easing would have beenundertaken to counteract the recession (assuming the NAIRU had not greatly changed since 1994). If the core CPI is used, the confidence interval narrows a little, to a range of 4.5% to 6.9%, but theinterval is arguably still too wide for meaningful policymaking.

Despite its shortcomings, the natural rate of unemployment is arguably a concept so deeplyingrained in economic policymaking that it would be difficult to imagine how to formulatepolicymaking without it. Decisions to tighten or ease monetary policy are fundamentally based onthe notion that the economy is above or below full employment, respectively. Full employment, inturn, is primarily determined by comparing the actual unemployment rate to an estimate of thenatural rate. As Mankiw and Ball argue,

Few economists would deny that shifts in aggregatedemand, such as those driven by monetary policy, push inflation and unemployment in oppositedirections, at least in the short run. That is all one needs to believe to accept the NAIRUconcept. (36)

The alternative to giving pre-eminence to the natural rate in policymaking decisions wouldbe to demote the natural rate to one among many economic variables in attempting to predict thepresent and future course of economic activity. (37) Rather than target the (unknown) natural rate of unemployment,policymakers can target sustainable economic growth, using an estimate of the natural rate as onevariable to help determine sustainability. Even for strict inflation targeters, who subordinateeconomic stabilization to price stability, a natural rate would be useful if it (as one of manyvariables) can help predict the future course of inflation. (38) Based on past experience, it can be argued that other indicators(such as the capacity utilization rate) do a better job predicting future economic activity than thenatural rate, particularly since changes in the natural rate are not easily identified. (39) Nevertheless, some ofthese better predictors are not as comprehensively or well grounded in economic theory as the naturalrate, increasing the likelihood that their past predictive capabilities were simply coincidental. Evenif the natural rate is relegated to one of many indicators of a fully employed economy, without theconcept of the economy moving above or below full employment, it does not seem clear howdecisions to change macroeconomic stabilization policy could be made.