NAIRU Rising: Policy Risk in the New Normal
That measure exists. It is the Non Accelerating Inflation Rate of Unemployment, or NAIRU, and it is the level of unemployment at which inflation will remain stable at a low level.
The trouble is that NAIRU "“ the level of unemployment necessary to keep inflation in check "“ isn't really knowable in real time, but anecdotal evidence suggests that this rate is indeed rising. A higher NAIRU in turn creates an inflation risk if underestimated by policymakers tasked with the competing goals of maintaining maximum employment and fighting inflation. Put another way: Hit the gas too hard to try to drive unemployment below the (unmeasureable) NAIRU, and you create the potential for inflation to set in. NAIRU has been estimated by the Congressional Budget Office (CBO) to be as high as 6.3% in the mid 1970s to as low as about 4.8% for the current decade.
Economists generally agree that an economy with a low growth rate will have a higher NAIRU, a view explained with Nobel Prize-winning passion by economist Edmund Phelps, who argued that NAIRU is anything but certain because, among other reasons, the rate depends in part on the willingness of entrepreneurs and small business owners who have historically been counted on to innovate and add new jobs.
PIMCO does not believe that the current level of unemployment is close to NAIRU, but we do believe that in a slower growth New Normal, as we term it, NAIRU may well be higher than earlier in this decade.
The thinking here is severalfold: Some workers have been out of work so long that their skills have declined. Meanwhile, the restructuring of the economy means that some skills have become either obsolete or less necessary. (Think mortgage broker.) Also, workers are not as able to relocate to where jobs might be available, in part because they can't sell their homes. And those small business owners, facing increasing taxation and regulation and having less access to financing, may not be as eager or as able to grow and to hire. In the short term, rising unemployment may help lower inflationary pressures, but longer-term structural unemployment of those who cannot or are too discouraged to find work can leave a permanent scar on the economy, as the "natural" unemployment rate pushes higher.
A term from physics may help describe this phenomenon: hysteresis: An equilibrium situation, once disturbed, may not return to the original equilibrium. In other words, "stable employment" may be at a different level"”a New Normal.
The gap between the actual unemployment rate and NAIRU theoretically helps policy makers adjust monetary policy. The dual mandate of the Federal Reserve of full employment and low inflation depends critically on being able to know generally where full employment (NAIRU) is in relation to current employment levels. While NAIRU cannot be ascertained effectively in real time, the actual unemployment level in the first half of 2010 seems well above anyone's estimate of stable unemployment, which helps provide clear information to the Fed. Later, as unemployment declines, the issue of the "true" but unmeasurable NAIRU becomes critical to Fed decisions.
Too much faith in the prevailing estimate of the unemployment gap may lead to policy errors. So, what if NAIRU for the years ahead were closer to 7% rather than the 4.8% rate estimated by the CBO? This would mean there is a much smaller unemployment gap and less maneuvering room to maintain loose monetary policy. Ignoring the impact of the financial crisis on the unemployment gap could lead to a miscalculation of that unemployment gap, and the resulting inflation risks could be higher in the medium term than presently priced by the markets. The blunt policy tools of monetary and fiscal policy to reduce unemployment could unintentionally stoke eventual inflation while attempting to reduce politically unacceptable high levels of unemployment.
Certainly other factors beyond the level of unemployment affect inflation. But an understanding of a potentially higher NAIRU is important for those who determine monetary and fiscal policy "“ and for investors whose portfolios need a proper inflation hedge.
This material contains the current opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2010, PIMCO.
Related Insights Economic Outlook 2010 A selection of articles that discuss the origin, causes and trajectory of the New Normal as well as the implications for investors.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2010, PIMCO.
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