What happens when the unemployment rate is less than the natural unemployment rate?

It may take considerable time for the economy to recover and jobs to return. Should the U.S. again experience the halcyon days of a 3.5% rate, that would seem to be a good thing. Then why were some pundits only recently asking what may seem like an illogical question: Is the unemployment rate too low?

The unemployment rate is defined as the percentage of workers who are unemployed and actively looking for a job. Why would 3.5% be too low? Is it really a detriment to the economy when most people who want them have jobs?

Key Takeaways

• Low unemployment is usually regarded as a positive sign for the economy.
• A very low a rate of unemployment, however, can have negative consequences, such as inflation and reduced productivity.
• When the labor market reaches a point where each additional job added does not create enough productivity to cover its cost, then an output gap, or slack, happens.

A Question of Productivity

The labor market will reach a point where each additional job added does not create enough productivity to cover its cost, making every successive job after that point inefficient. This is the output gap, often called the “slack” in the labor market. In an ideal world, an economy has no slack, meaning the economy is at full capacity and there is no output gap. In economics, slack is calculated by U6 minus U3, where U6 is the total unemployment, hidden unemployment, and part-time workers seeking full-time work, and U3 is simply total unemployment.

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Just as an economy rises and falls, so does the output gap. When there is a negative output gap, the economy’s resources—its labor market—are being underutilized. Conversely, when there is a positive output gap, the market is overusing resources and the economy is becoming inefficient. This occurs when the unemployment rate falls.

The level at which unemployment equals positive output is highly debated. However, economists suggest that as the U.S. unemployment rate gets below 5%, the economy is very close to or at full capacity. So at 3.5% one could argue the level of unemployment is too low, and the U.S. economy is becoming inefficient.

Wage inflation is a particular problem for small-cap firms, which often lack the margins to cope with it.

Rising Wage Inflation

Rising wages can often be beneficial. However, across certain industries, wage inflation above the natural pace of inflation is a bad thing. Sectors such as industrials and consumer discretionary struggle with wage inflation, and small-cap firms don’t have the margins to cope with rising wages. Smaller companies generally have lower profit margins and less revenue per employee, making it more difficult to pay higher wages, as Ben Snider and the portfolio strategy team at Goldman Sachs told a MarketWatch.com reporter in a 2017 note. They estimated that a 100 bp acceleration in labor cost inflation would pose a 2% headwind to Russell 2000 EPS, roughly doubling the 1% impact they estimated for the S&P 500.

Wage inflation comes about by increasing demand for labor as the unemployment rate is falling. With fewer people available to work, employers are forced to increase wages to attract and hold on to talent. A knock-on effect from rising wages is that some small firms have to dip into the less talented work pool, reducing productivity.

The Bottom Line

When the Federal Reserve adjusts monetary policy in an attempt to reach the sweet spot of full capacity, it is faced with both economic and social problems. Accelerating wage inflation from very low unemployment may dent profits, but what can be done about it? The reality is: not much. You can’t deny people the opportunity to look for work.

Natural unemployment, or the natural rate of unemployment, is the minimum unemployment rate resulting from real or voluntary economic forces. Natural unemployment reflects the number of people that are unemployed due to the structure of the labor force, such as those replaced by technology or those who lack certain skills to gain employment.

Key Takeaways

• Natural unemployment is the minimum unemployment rate resulting from real or voluntary economic forces.
• It represents the number of people unemployed due to the structure of the labor force, including those replaced by technology or those who lack the skills necessary to get hired.
• Natural unemployment persists due to the flexibility of the labor market, which allows for workers to flow to and from companies.

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Natural Unemployment

Understanding Natural Unemployment

We often hear the term “full employment,” which can be achieved when the U.S. economy is performing well. However, full employment is a misnomer, because there are always workers looking for employment, including new college graduates or those displaced by technological advances. In other words, there is always some movement of labor throughout the economy. The movement of labor in and out of employment, whether it’s voluntary or not, represents natural unemployment.

Any unemployment not considered to be natural is often referred to as cyclical, institutional, or policy-based unemployment. Exogenous factors can cause an increase in the natural rate of unemployment; for example, an economic crash or steep recession might increase the natural unemployment rate if workers lose the skills necessary to find full-time work or if certain businesses close and are unable to reopen due to excessive loss of revenue. Economists call this effect “hysteresis.”

Important contributors to the theory of natural unemployment include Milton Friedman, Edmund Phelps, and Friedrich Hayek, all Nobel winners. The works of Friedman and Phelps were instrumental in developing the non-accelerating inflation rate of unemployment (NAIRU).

Why Natural Unemployment Persists

It was traditionally believed by economists that if unemployment existed, it was due to a lack of demand for labor or workers. Therefore, the economy would need to be stimulated through fiscal or monetary measures to bolster business activity and ultimately the demand for labor. However, this method of thinking fell out of favor as it was realized that, even during robust economic growth periods, there were still workers out of work due to the natural flow of workers to and from companies.

The natural movement of labor is one of the reasons why true full employment can’t be achieved, as it would mean that workers were inflexible or unmoving through the U.S. economy. In other words, 100% full employment is unattainable in an economy over the long run. True full employment is undesirable because a 0% long-run unemployment rate requires a completely inflexible labor market, where workers are unable to quit their current job or leave to find a better one.

According to the general equilibrium model of economics, natural unemployment is equal to the level of unemployment of a labor market at perfect equilibrium. This is the difference between workers who want a job at the current wage rate and those who are willing and able to perform such work. Under this definition of natural unemployment, it is possible for institutional factors—such as the minimum wage or high degrees of unionization—to increase the natural rate over the long run.

Ideas about the relationship between unemployment and inflation are continuing to evolve.

Unemployment and Inflation

Ever since John Maynard Keynes wrote “The General Theory” in 1936, many economists have believed there is a special and direct relationship between the level of unemployment in an economy and the level of inflation. This direct relationship was once formally codified in the so-called Phillips curve, which represented the view that unemployment moved in the opposite direction of inflation. If the economy was to be fully employed, there must be inflation, and conversely, if there was low inflation, unemployment must increase or persist.

The Phillips curve fell out of favor after the great stagflation of the 1970s, which the Phillips curve suggested was impossible. During stagflation, unemployment and inflation both rise. In the 1970s stagflation was in part due to the oil embargo, which sent oil and gasoline prices higher while the economy sank into recession.

Today economists are much more skeptical of the implied correlation between strong economic activity and inflation, or between deflation and unemployment. Many consider a 4% to 5% unemployment rate to be full employment and not particularly concerning.

The natural rate of unemployment represents the lowest unemployment rate whereby inflation is stable or the unemployment rate that exists with non-accelerating inflation. However, even today many economists disagree as to the particular level of unemployment that should be considered the natural rate of unemployment.

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