The Federal Reserve faces a big risk: Once it lets the economy go too far in one direction, it can be difficult to turn around, so when the unemployment rate gets very low and then starts rising, it tends to rise a lot.
Stable inflation and low unemployment suggest the U.S. economy is enjoying a Goldilocks moment, running neither too hot nor too cold to cause much hardship for households. But how low can joblessness fall, and for how long, before a boon for the economy turns into a burden for everyone?
Since the end of the most recent recession, U.S. unemployment has fallen from nearly 10% to 3.9% in April. If unemployment runs too low for too long, inflation or dangerous financial bubbles could build. The last three times the jobless rate has moved below 4%—in the 1950s, 1960s and late 1990s—the U.S. got one of those outcomes and recession eventually followed.
Economists and central bankers have long tried to put numbers to the Goldilocks fable. They pay close attention to a theoretical threshold at which the economy is in balance and inflation pressures are neither rising nor falling, called the “nonaccelerating inflation rate of unemployment,” or Nairu. Go much above or below Nairu, the theory holds, and you’ve got trouble.
The difficulty officials face in assessing Nairu is that it’s a moving target. In 2000, the jobless rate went below 4% for just five months before problems ensued—a tech bubble burst that led to recession. In the late 1960s, on the other hand, it stayed below 4% for nearly four years, leading to inflation and a decade of economic malaise.
Ryan Sweet, an economist at Moody’s Analytics, says Nairu is the economics profession’s Loch Ness monster: You might think you’ve seen it, but it’s always hard to know.
Over the past seven decades, Nairu has ranged from about 4.6% to just over 6%, according to the Congressional Budget Office’s economic projections.
Complicating matters, Nairu estimates rely on a contentious theory that falling unemployment pushes up prices and wages. That relationship appears to have broken down in recent years, when inflation remained below the Federal Reserve’s 2% target even as the jobless rate steadily declined.
There are several explanations for why. Nairu itself might not be a useful guide. Or the U.S. might not be at full employment yet. The White House’s chief economist, Kevin Hassett, said last month that full employment “could be in the threes now.”
A broader measure of unemployment that includes workers stuck in part-time jobs or too discouraged to search for work remains high, suggesting slack remains in the labor market. The measure fell to 7.8% in April from 8% in March, whereas in December 2000 it stood at 6.9%.
Former Fed Vice Chairman Alan Blinder points to his “traumatized worker” theory. “Workers still remember the bad old days and they’re more interested in job security than they are in seeking out a raise,” he said.
This time around, some economists worry that low inflation, low unemployment and historically low short-term interest rates could be a recipe for a different problem, potentially disastrous financial bubbles. The past two recessions were ushered in by a rise and subsequent collapse in asset prices. In both cases, the unemployment rate dropped to low levels as asset prices soared, hitting 3.8% in April 2000 and 4.4% in October 2006.
Signs of financial excess are building now. Net wealth of American households—driven by their stock, bond and real-estate investments—was nearly seven times their income in the fourth quarter of 2017, above levels seen during the Nasdaq bubble and the housing boom.
The Federal Reserve’s job is to manage the heat on Goldilocks’ porridge pot by moving interest rates higher and lower. It pushes interest rates down when it wants to spur economic growth by encouraging businesses and households to invest and spend more. It pushes interest rates up when it wants to cool investing, spending and growth.
The Fed’s rough estimate for Nairu is now around 4.5%. Officials project the actual jobless rate will drop to 3.8% by end of this year and reach 3.6% in 2019 and 2020. That suggests the Fed is prepared to let the unemployment rate fall to a level not seen since the late 1960s before it would cool the heat by considering a more aggressive pace of rate increases.
One big risk faced by the Fed: Once it lets the economy go too far in one direction, it is hard to turn it around. When the unemployment rate gets very low and then starts rising, it tends to rise a lot.
“The Fed has never been able to get the unemployment rate up from significantly below Nairu back to Nairu without a recession ensuing,” Deutsche Bank economist Peter Hooper said on a panel at the Brookings Institution earlier this year.
The Fed expects it will raise short-term interest rates two more times this year, in quarter-percentage-point increments. If the unemployment rate steams lower, the Fed might find itself moving more aggressively than planned.