The U.S. Federal Reserve has a complicated mandate. The legislation governing this agency states the Fed is supposed to “promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” It does this by controlling or influencing interest rates and controlling the U.S.’s money supply. The Fed has pushed down interest rates close to zero for many years to increase the number of employed people and reduce unemployment. By pushing interest rates down, it has explicitly ignored two of its three mandates. The key question for the Fed is when should it stop focusing on employment and refocus its attention on stable prices and moderate long-term interest rates?
A few days ago the Bureau of Labor Statistics released its assessment of unemployment. The Bureau found that “the unemployment rate was unchanged at 5.5 percent.” This makes the second month in a row that the US rate has been at 5.5%. This 5.5% figure is an important value for both employment and stable prices.
Labor economists often talk about the “non-accelerating inflation rate of unemployment,” abbreviated NAIRU. This is also called the natural or normal rate of unemployment. The idea behind NAIRU, the natural or normal rate is simple. Whenever there is a shortage, prices rise. Whenever there is a surplus, prices fall. Labor in the NAIRU model is just like cars or fruit. Whenever there is a surplus of cars, fruit or workers looking for jobs, prices fall. Whenever there are too few cars, fruit or unemployed workers, prices for each of these items rise.
The level at which there are too few workers is NAIRU. If the unemployment rate is above NAIRU, wage rates don’t go up. When unemployment is below NAIRU, wages start rising because businesses face worker shortages.
The U.S. government’s estimates of NAIRU are done by the Congressional Budget Office. The CBO is a nonpartisan organization that provides analysis for the U.S. Congress so that not just politics but sound analysis is behind the nation’s rules and laws. The CBO estimates NAIRU once a year and the indicator is posted both on the CBO website and on the website of the St. Louis Federal Reserve. Last year , in 2014, the CBO estimated that the natural rate of unemployment for the US economy in 2015 was 5.5%. This is the level we have been at for two months in a row. The CBO recently revised the natural rate. Their new estimate, shown below, is that the natural rate or NAIRU is 5.4% in 2015, one-tenth of a percent below our current rate.
The CBO’s NAIRU estimates suggest the US economy has reached the point where support from the Federal Reserve is either unwarranted or very close to being finished. However, the Fed’s most recent press release states something very different. They say “it will be appropriate to raise the target range for the federal funds rate when it has seen further improvement in the labor market.”
In simple terms the FED is saying that the U.S. has a natural rate that is much lower than 5.5%, without stating a particular number. Does the Federal Reserve know more than other government economists about the labor market? This is not an arcane question since mistakes by the Federal Reserve can result in an economic catastrophe. Ben Bernanke, the former Chairman of the Federal Reserve gave an amazing speech while he was leading the Fed that stated Federal Reserve mistakes caused grave economic hardship during the Great Depression.
In my opinion the Fed, by artificially depressing interest rates since the recession of 2007-08, has embarked on a dangerous experiment which has gone on far too long. Ignoring the NAIRU put forth by other government economists and underestimating the natural rate means the Fed is on track to make a serious mistake today, like it did during the later 1920s and 1930s.