Not the sexiest title, I grant you, but important stuff, nevertheless.
Those of us interested in just how close we are to full employment like to track the more comprehensive “u6” rate, aka, “underemployment.” It includes all the unemployed, but also the millions of involuntary part-timers (IPT)—who are, quite literally, underemployed—plus a small subset of those out of the labor market who might be willing to work if there were more good opportunities available. Especially because IPT has been so elevated in this recovery, and because some special factors, like depressed labor force participation, have led to a downward bias of the unemployment rate, u6 is worth watching closely.
As you see below, u6 rose more in the Great Recession and has fallen faster in the expansion than the official rate.
Unemployment and Underemployment (u6)
Now, for reasons I’ll explain, it’s necessary to guesstimate to the “natural rate” of unemployment, i.e., the unemployment rate consistent with stable prices. The Fed thinks it’s about 5% which is where we are now, ergo, they’re getting ready to raise rates.
But I think that these days, it’s better to gauge slack using u6, which last clocked in at 9.8%. But where is that relative to the natural rate of underemployment?
The (justifiably) influential macro team at Goldman Sachs believes that the natural rate for u6, call it u6*, is 9%. That’s about where u6 stood at the end of the last expansion (late 2007) when the official rate was at 5%, so not an unreasonable guess.
OTOH, as you can see in the figure, u6 was around 7% at the end of the 2000s expansion, when the official rate was around 4% (and inflation was perfectly well behaved, ftr). There are reasons to believe the “natural rate” is higher today than it was back then—certainly productivity and thus potential growth are lower now. And, of course, there are good reasons not to truck in this whole “natural rate” business at all; there’s no reliable way to nail it down, it moves around, and economists invariably tend to pitch it too high, at great cost to those who depend on truly full employment.
But here’s why it’s important: the Taylor Rule. This is the rule that says at least one Taylor Swift hit must be on pop radio at any given time (whoops—sorry—just a little whining from a chauffeur whose teenagers insist on controlling the radio). The other Taylor Rule is one of the methods the Fed employs to decide whether the interest rate they control needs to be raised, lowered, or left alone.
There are many variations of Taylor rules, and I’ll let you Google them to your heart’s content. They’re a touch controversial right now because House Republicans are trying to pass legislation to make the Fed follow some version of the rule, a terrible idea that Fed chair Yellen has inveighed against. Like I said, the rule is but one input and there are too many variants to reliably count on it to give anything more than a range of impressionistic answers as to where the Fed funds rate (ffr) should be set.
The rule is just a formula that takes data on inflation and slack and spits out an ffr. If you use the version Yellen describes here in footnote #5, and you plug in u6 instead of the official rate for slack, as I strongly think you should, you have to, as part of the formula, guesstimate u6* (the natural rate for u6).
So that’s what I did, using a few different methods (data available upon request).
1) regress u6 on Levin’s comprehensive slack variable, such that u6*=the intercept term, i.e., underemployment when slack=0.
2) regress u6 on the difference between the unemployment rate and the CBOs natural rate; the intercept is again the natural rate.
3) same as #2 but just plug in 4.5% for CBO’s natural rate, under the assumption that they peg it too damn high.
The table shows the results, using Yellen’s ftnt 5 version of the Taylor rule, and the most recent observation of year/year core PCE inflation (1.3%).
If, like the GS team, you think u6* is 9%, the rule returns 0.17% which is about where the Fed’s likely heading in a few weeks, when they raise the ffr by 25 basis points.* If you think u6* is something less than that, as I do–my prefered u6* is 8.5%–you’d be in less of a rush to get started with your “normalization campaign” as the rule says the economy still needs a negative real rate to get back to full employment.
But these differences are small and there are many sensitive assumptions built into the calculations. As I’ve said here re Fed liftoff plans, go ahead and raise a tiny bit if you must. What matters now is the path of future increases which, if we are to get to and stay at truly full employment, should surely be shallow and driven by the extent to which income and wage growth are reaching those who have heretofore been left behind.
*Update: The GS team now pegs u6* at 8.7%, slightly above my preferred estimate (no link, sorry). Nice move, GS!