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. 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 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 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) "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) 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.