What does “full employment” mean in the era of anchored inflation expectations?

October 15th, 2018 at 6:00 am

There’s a new analysis out by a group of economists from the Goldman Sachs economic research team that raises the question of what the concept of full employment means in an era when the central bank expends significant and successful efforts to anchor inflationary expectations.

The paper (which lives behind a paywall) uses four distinct techniques to to derive different estimates of the natural rate of unemployment, aka u*, aka the lowest unemployment rate consistent with stable inflation. The results range from 4 to 4.8 percent, which, as their figure below shows, fit well within other commonly sourced versions, including CBO (4.6 percent) and the Fed (4.5 percent). Note also their forecast for the jobless rate to get to 3 percent (!) by the end of next year. As they say in the old country: “from their lips to Keynes’ ears.”

Source: GS Research

For those who are interested, I’ve pasted in their table at the end of this post which briefly describes their four methods and results, but anyone who still subscribes to Phillips Curve notions of full employment might well ask: “why, if the current unemployment rate is below all these estimates of the natural rate, is there so little acceleration in core inflation?” Here is their conclusion (my italics):

“The actual unemployment rate is already below all of these estimates, and we expect it to fall all the way to 3% in early 2020.  But…such a scenario is not as dramatic as it sounds: with well-anchored inflation expectations, a labor market overshoot is likely to result in above-target inflation, but not persistently accelerating inflation.  This is an important difference with the late 1960s, when labor market overheating led to runaway inflation.”

Now, one of my constant refrains these days is that the Fed’s 2 percent is an average target, not a ceiling. Given the many years of downside misses on the inflation target, we’re long overdue for a period of “above-target inflation.” So, if these analysts are correct, as I suspect they are, then this overshoot is a feature, not a bug.

If that’s true—if an unemployment rate significantly below the Fed’s natural rate estimate means we get something we very much want (super tight labor markets) as opposed to something we very much do not (spiraling inflation)—then, conditional on inflationary expectations remaining well-anchored, being above full employment is precisely where we should aspire to be.

This is an awfully different economic model. In this model, go ahead and bang out estimates of the natural rate if you must, but recognize that (u-u*)<0 (actual unemployment below your estimate) is not a signal to hit the growth brakes. In this model, your real job is to watch the indicators of inflation expectations and realizations. And if, as is currently the case, they seem well-contained, then there’s no reason to overreact.

One interesting aspect of this conclusion is that those of us who have criticized the Fed’s anchoring as being a drag on demand relative to more flexible inflation or level targeting (I’m talking to you, Beckworth) might consider that at least under this framework, solid anchoring enables stronger demand and lower unemployment than would otherwise prevail.

However, for those who benefit the most from such low unemployment to realize such gains, the members of the FOMC would have to recognize these dynamics. I actually think Chair Powell does, and he’s not alone, but there are others who look at that 3 percent at the end of the figure above and think, “not on my watch!”

Source: GS Research

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3 comments in reply to "What does “full employment” mean in the era of anchored inflation expectations?"

  1. Vic Twente says:

    There was runaway inflation in the 1960s? Really? Before the Arab oil embargo?


  2. Kevin Rica says:

    I think much bigger questions are “Are “Full Employment” and “Potential Output” the same thing?” “Is a modern economy constrained by a lack of unemployed, low-skilled, low-wage, first-hired, last-hired laborers?” Is that the binding constraint? Because the big inflation trigger should be when aggregate demand exceeds (potential output + net inputs).

    I can think of other output constraints, including the capacity of installed plant and equipment or energy availability. We’ve certainly had several energy shocks in the past half century and a lot of tradeable-goods capacity has been destroyed by the “China Shock,” but, unfortunately, there has been no general “wage shock.”

    It’s possible that when an economy has been at full employment with a compatible capital stock then the terms “Full Employment” and “Potential Output” might be roughly synonymous. However, after a long-term period of weak demand that link might be broken. Or, “Full Employment” and “Potential Output” might move together without a direct causal connection. But looking at the number of low-skilled, low-wage, first-hired, last-hired workers may not even measure potential output. So even if there was a Phillips Curve correlation between U3 and inflation, it may not even have been causal.

    And if we did hit full employment as a constraint on output, wages should start to rise before output hits its limit. In effect, what the Fed has been targeting is employment and wages, not inflation, based on a questionable correlation that has broken down.


  3. Bill Anderson says:

    Full employment is when non-sup wages go to 3.5-4.0. The real problem the government is having this cycle, is keeping track of Baby Boomers who bailed out during the recession, were too young to retire and came back in…………………on disability. They shouldn’t be looking for work, but they are imo. This is whats holding back wages. When LFPR began to level off in 2013, it probably should have started rising up to a new threshold, probably not 66%, but something more in the 64-65% range. This would raise unemployment.


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