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Estimating Key Economic Variables: The Policy Implications.

Abstract The current monetary policy debate has focused on current estimates and the future path of the natural rate of unemployment and the equilibrium interest rate. Estimates of the natural rate of unemployment should vary over time with changes in demographics and improvements in human capital. However, these changes should be gradual. This paper shows that the estimates of the natural rate of unemployment by Federal Reserve officials and private-sector economists seem to move pro-cyclically, potentially showing too much weight given to short-term fluctuations in economic variables. As with the natural rate, there are good reasons to expect the equilibrium interest rate to change over time. In fact, the level may actually be more responsive to current economic data, reflecting changes in aggregate savings and investment. Yet, we see that equilibrium interest rate estimates by both Federal Reserve officials and private-sector economists have declined quite dramatically over the past five years. A potential concern raised in this paper is that estimates of these critical economic variables for policy determination appear to be overly sensitive to high frequency economic data.

Keywords Natural rate of unemployment * Equilibrium interest rate

JEL E52-E58

Introduction

Every economic recovery has unique puzzles. (1) One puzzle in the most recent recovery is why it has been so difficult for central banks in many developed economies to achieve their inflation objectives, even as employment has rebounded. Both Japan and the U.S. are at or beyond many estimates of full employment, and the Euro Area has made significant progress toward full employment. Yet, inflation in all three areas remains below targets set by their respective central banks. One would expect robust employment conditions to nudge up wages and, in turn, prices, leading the inflation rate toward its target.

One possible explanation for this puzzle could be that what economists call the "natural rate" of unemployment (i.e., the unemployment rate that is consistent with an inflation rate at its target value) may have fallen. A lower natural rate of unemployment in the economy might explain why lower actual levels of unemployment are not driving up wages and prices as quickly as some expected. In fact, Federal Reserve policymakers (the participants in the FOMC) have lowered their estimates of the unemployment rate that they expect in the long run.

While it is certainly possible that the natural rate of unemployment for the U.S. economy is now lower, I believe some caution is in order in making this assessment. Short-run estimates of the natural rate have tended to follow the actual unemployment rate fairly closely. Hence, policymakers' estimates of full employment (2) tend to be lower when the economy is doing well and higher when the economy is doing less well. But with the benefit of hindsight, estimates of the natural rate are less variable than initially thought, tracking actual unemployment less closely (Aaronson et al. 2015).

Modest and gradual movements in the natural rate are consistent with the sense that long-term economic trends, such as improvement in human capital and demographic changes, are the main source of variation in the natural rate. Such changes are unlikely to occur quickly or in unexpected ways over relatively short time periods, such as over a business cycle. Since I do not believe a significant decline in the natural rate of unemployment explains the subdued-inflation puzzle, it remains just that, a puzzle.

A second surprise in this recovery has been the relatively slow rate of economic growth we have experienced in the U.S. despite unusually low interest rates. While short-term real interest rates have actually been negative throughout the recovery (very accommodative monetary conditions), the economy has grown at only a rather tepid rate of about 2%. A common explanation for this dynamic has been that the equilibrium interest rate (the interest rate that in the long run is consistent with stable inflation and full employment) has fallen.

In this case, the movement does seem more understandable. What policymakers call "potential gross domestic product (GDP) growth" has declined. Indeed, FOMC participants are surveyed on their views of what the long-run sustainable interest rate and GDP growth rate will be in the longer term. Both estimates have fallen quite substantially.

However, like the natural rate of unemployment, the equilibrium interest rate can only be inferred rather than known. The rapid decline in estimates of the equilibrium interest rate should also be viewed cautiously, given the imprecision in estimation and given how much estimates have varied over a relatively short time period.

The relatively rapid changes in these estimates of variables like the natural rate of unemployment and the equilibrium interest rate may reflect actual changes in economic relationships. However, they also may attempt to explain developments in "high frequency" information with changes in relatively "low frequency concepts," and stretch too far in attempting to explain developments in economic measures. While attempting to infer possible long-run changes or implications from recent high-frequency data may be reasonable, history shows that policymakers tend to place too much weight on short-term fluctuations in their real-time estimates of long-run concepts.

This tendency is of more than academic interest. One can make significant policy mistakes if one assumes incorrectly that significant changes in long-run variables have occurred, when in fact no change has occurred. (3) Central bankers should hesitate to change their policy stance based on estimated changes in long-run variables that are not large in statistical terms, relative to the standard errors with which these quantities are estimated.

In my own view, maintaining negative real short-term rates once we have achieved full employment risks the potential of an eventual overheating of the economy, which could be reflected in higher wages and prices, or higher asset prices. Already-tight labor markets are likely to tighten further as the economy continues to grow faster than its potential. In these circumstances, prudent risk management would argue for the continued gradual removal of monetary policy accommodation in order to minimize the risk of outcomes that might prematurely shorten the current economic recovery.

Recovery Puzzles

It is not particularly surprising that the economic recovery in the wake of a financial crisis has been quite slow. Studies of earlier episodes find that recoveries following financial crises are usually slow as firms and households are understandably more risk averse, and the collateral values that are essential for obtaining financing are slow to rebound. However, what has been more surprising is how slowly wages and prices are growing a decade after the onset of the Great Recession. (4)

Figure 1 shows the unemployment rate in the U.S., the Euro Area, and Japan. By this measure, there has been significant improvement in all three economies. In both the U.S. and Japan, unemployment rates are now below levels reported immediately prior to the Great Recession. In the case of the Euro Area, the unemployment rate is still elevated, but is on a path reflecting relatively consistent improvement.

In contrast, Figure 2 shows that the progress on achieving stated inflation targets has been somewhat disappointing. In all three regions, inflation rates are currently below their 2% targets. While there have been periods during the recovery when measures of total inflation have temporarily exceeded 2%, the inflation rate has remained below target for much of the recovery. For example, the total personal consumption expenditure (PCE) inflation rate in the U.S. over the last year has most recently averaged only 1.8%. In Japan, the inflation rate has been particularly low, possibly reflecting a fall in the expected inflation rate due to the very long period when actual inflation has been below the 2% target.

One Puzzle: Implications of Low Inflation

During periods of substantial slack in the economy, it is not surprising that wage and price inflation are modest. However, as we reach or exceed many economists' estimates of full employment, one might expect that wage and price pressures would gradually increase. One way that economists try to capture this relationship is through the Phillips Curve, which describes inflation as being generated by expectations of future inflation and the amount of labor-market slack in the economy. One challenge of this simple formulation involves how best to capture the amount of slack in the economy. The measurement of slack depends on obtaining an estimate of the natural rate of unemployment. (5)

Figure 3 provides estimates of the natural rate of unemployment and forecasts of the unemployment rate in the longer run. The solid line is the median of FOMC policymaker estimates of the unemployment rate in the longer run, from the Federal Reserve's Summary of Economic Projections (SEP). (6) Since this is a survey, the estimates reflect what participants knew as of the time of the survey. Participants are asked the unemployment rate they expect in the longer run, assuming an absence of shocks and assuming appropriate monetary policy. A second measure (dashed line) is the current Congressional Budget Office (CBO) estimate of the natural rate over the same time period. Since the financial crisis, the median estimate of FOMC participants has moved from a high of 5.45%, to the current low of 4.6%. The shaded region provides the SEP "central tendency," the range of estimates provided by FOMC participants after excluding the three highest and three lowest responses. At times, even though the range is quite large, the bottom of the range lies above the CBO estimate of full employment, as it does from mid-2011 through 2015.

How reasonable are the estimates of the natural rate? The range of estimates highlights the uncertainty entailed in measuring this key variable. While the natural rate will change over time, most of those changes reflect gradual but significant changes in demographic characteristics of the labor force. For example, when (typically) younger workers first enter the workforce, they are more likely to be unemployed, as they may not as yet have developed marketable skills, and are thus more likely to shift jobs. In addition, they are more likely to leave the workforce to gain additional skills through higher education or training. The opposite is true of more experienced and older workers, who have developed job-specific capital and are therefore more attached to their work and less likely to become unemployed or leave the labor force. So historically, when demographics have resulted in a higher share of younger workers in the labor force, the natural rate appears to have risen--relative to times when young workers are a smaller share of the labor force.

Figure 4 shows the share of the labor force between the ages of 16 and 24 and the CBO's estimate of the natural rate of long-term unemployment. The chart shows that with the aging of the baby boom generation, younger workers have become a relatively smaller share of the labor force. At the same time, the CBO's estimate of the natural rate has declined.

Figure 5 provides the share of the labor force--age 25 years and older--with at least a college degree, which has trended up over time. Better educated workers tend to have lower unemployment rates when compared with those with less educational attainment. As a result, one might expect this trend to be reflected in a lower natural rate of unemployment.

While these figures provide possible explanations for why the natural rate may change, it is important to realize that broad demographic trends are generally slow moving, well-known in advance, and thus straightforward to predict. While these trends can make a difference and do seem consistent with the moves seen in the CBO estimate of the natural rate, it is hard to match these broader demographic changes with relatively rapid and recent changes in the estimates of the natural rate seen in the SEP forecasts.

An alternative explanation of the degree of movement in the presumed natural rate may be that forecasters are overly sensitive to current economic conditions when estimating the current natural rate. When the unemployment rate is quite high, we may associate too much of the higher unemployment rate to difficulties in matching workers to jobs. Similarly, when labor markets are very tight, as is the case presently, estimates of the natural rate may fall too much.

Figure 6 shows estimates of the natural rate of unemployment based on the Survey of Professional Forecasters. (7) The chart shows that the median estimate of the natural rate of unemployment has shown substantial fluctuation. While these estimates are currently at 4.5%, they were at 6% after the recession. At that point, when the estimates were quite high, there was also significant divergence in views, with the interquartile range--shown here with the shading--sometimes exceeding 1%. Interestingly, the interquartile range is quite tight presently, suggesting much less divergence in the views of forecasters now than has been the case over the past decade.

Again, the median estimate of the natural rate of unemployment has shown substantial fluctuation. Intuitively, it makes sense that sharp movements in a relatively short time period would not be driven by slowly moving variables such as demographic or educational changes in the workforce. As a result, it seems highly likely that estimates could be influenced by and unduly tied to economic conditions prevailing at the time the survey is done.

Figure 7 shows the estimates of the unemployment rate in the longer run from the Survey of Primary Dealers (8) over the past five years. While there is a somewhat limited time series, since the survey only included a longer-run unemployment rate question beginning in mid-2012, it follows fairly closely the path of the Survey of Professional Forecasters: In 2012, the median estimate was 6% and has now declined to 4.5%.

Figure 8 provides another look at the natural rate of unemployment estimates of the Survey of Professional Forecasters, this time in the context of the SEP and CBO estimates. The figure shows that when estimates of the natural rate rose after the Great Recession, the Survey of Professional Forecasters' median was often higher than the top of the central tendency of the SEP. In contrast, it is currently near the lowest estimates of the central tendency. (9) Thus, while policymakers could be perceived to be too sensitive to current economic conditions, professional forecasters have moved their estimates even more.

Figure 9 shows the actual unemployment rate with the median SEP estimate of the natural rate, and the CBO estimate of the natural rate since mid-2014. The actual unemployment rate is now below both estimates of the natural rate--and estimates of the natural rate are now lower than they were just three years ago. The SEP estimates, reflecting real-time estimates of the natural rate, move more closely with actual unemployment than the CBO estimate, which has the benefit of hindsight. This suggests exercising caution in making our natural rate estimate too responsive to incoming data. (10)

A Second Puzzle: The Low Equilibrium Rate of Interest

A second foundational concept that is difficult to estimate is the "normal" level for the federal funds rate--or what policymakers call the equilibrium nominal interest rate. As with the natural unemployment rate, the equilibrium interest rate is a concept that cannot be directly observed, but must be estimated. Also similar to the natural rate, a good proxy for estimates by FOMC members of the equilibrium funds rate is their SEP estimates for the nominal federal funds rate "in the longer run."

Figure 10 provides the SEP forecasts since 2012. While the funds rate in the longer run was estimated at 4.25% early in the recovery, the estimate in the most recent SEP had fallen to 2.75%. Like the natural rate, there is significant variation in these estimates over time, as well as significant disagreement among SEP participants at any point in time. As the shaded region shows, the lower boundary of the central tendency of the estimates of the equilibrium interest rate early in the sample are well above most estimates just a few years later.

Figure 11 shows the estimates of the federal funds target rate in the longer run from the Survey of Primary Dealers. Primary dealers' estimates of the equilibrium estimate show a significant decline, very similar to the SEP.

As with the natural rate, there are good reasons to expect the equilibrium interest rate to change over time. In fact, in this case, the level may actually be more responsive to current economic data. If we think of the interest rate as determined by the balance between savings and investment, then changes in the equilibrium interest rate will occur when the key factors determining aggregate saving and investment decisions change. These include demographic changes, which can affect global saving behavior (younger workers generally save less and older workers save more), and changes in productivity, which affect the demand for investment goods (higher productivity generally spurs investment, as it implies higher returns per dollar spent on invested goods). Increases in the propensity to save will place downward pressure on equilibrium interest rates, as the higher demand for saving implies a lower required interest rate.

In this case, one might expect to see more significant changes as, for example, variables that impact aggregate savings and investment can change. In fact, SEP participants' estimates of the equilibrium interest rate have fallen significantly over a relatively short period of time. In sum, when it comes to estimating the equilibrium interest rate there may be more responsiveness to incoming economic data, and we should note that changes like much lower current estimates of productivity should impact this calculation. All in all, one should be cautious given the inherent difficulty in inferring where the equilibrium interest rate will be in the long run.

Potential Risks Facing Policymaking

Figure 12 provides the current forecast for the unemployment rate according to the Blue Chip Economic Indicators, a survey of approximately 50 forecasters. The December 2017 Blue Chip survey (Blue Chip Publications 2017) suggests the unemployment rate will fall below 4% and be at 3.9% at the end of 2018. Notably, there are many forecasters that expect that the unemployment rate will drop even further below 4%. This indicates that despite the tightening that has occurred to date, forecasters expect the unemployment rate to remain well below the natural rate of unemployment as estimated by the SEP, CBO, Survey of Professional Forecasters, and Survey of Primary Dealers.

To have the economy run persistently below what most economists view as sustainable in the long run has certain benefits, such as more workers who are more marginally attached to the workforce may obtain gainful employment, for instance. However, there are potential costs.

One potential cost might be that while inflation has been persistently below 2% during much of the recovery from the Great Recession, a prolonged overshoot of what is sustainable unemployment may, over time, lead to more inflation than is desired. While the Phillips Curve is estimated as being quite flat around full employment, it is possible that if the unemployment rate goes well below the natural rate, inflation may be more responsive to running the economy with such tight labor markets.

A second potential cost has to do with financial stability. That is, maintaining very low interest rates, despite tight labor markets, may result in much higher asset prices. Indeed, current commercial real estate valuations and stock price valuations indicate that those markets are starting to deviate significantly from their historical mean. Should the economy experience a negative shock, asset valuations could decline substantially at a time where there is very little room to move short-term interest rates in response.

A third risk, and potentially the greatest, could be that inflation picks up quickly enough that monetary policy can no longer move at a gradual pace. In this scenario, should monetary policy need to be tightened more quickly, the risk is increased that monetary policy could become tight enough to trigger a recession. In fact, I would note that in the past, during times that the unemployment rate has risen by 0.4 percentage points, a recession has ensued. With estimates of the natural rate around 4.5% and forecasts of the unemployment rate quite likely to fall to 4%, it is not difficult to envision the unemployment rate increasing by more than 0.4 percentage points.

Balancing these risks to the economic outlook depends, in part, on one's confidence in estimating the concepts of the natural rate of unemployment and the equilibrium rate of interest. However, as I have noted, such estimates are not precise and have moved significantly over the past 10 years. There is certainly some evidence that these movements may be too sensitive to current economic conditions, which challenges policymakers to be humble and consider a balanced approach that appropriately weighs the risks of deviating significantly from what they believe is sustainable.

Concluding Observations

While it is important that monetary policy be "data dependent," it is equally important that it not be too sensitive to incoming data, especially when estimating important underlying economic concepts like the natural rate of unemployment and the equilibrium interest rate. While underlying economic relationships can and do change, one should not be too quick to assume that relationships are unhinged as a result of expectation errors for "high frequency" data. It is certainly important to adjust estimates of underlying relationships when there are large persistent variations from estimated values, but too much sensitivity to incoming data can cause monetary policy to be too easy in expansions and too slow to respond to recessions.

In the current environment, the low inflation readings have provided monetary policymakers the opportunity to take a more patient approach to removing accommodation than in recent recoveries, allowing a prolonged period of recovery in labor markets. A gradual approach has many benefits, including the possibility of a long-sustained recovery without risking a significant over-reaction by monetary policymakers.

However, estimates of the natural rate of unemployment and the equilibrium interest rate can be too low as well as too high. In my own view, failing to respond to very tight labor markets with rates remaining negative in real terms could potentially risk unnecessarily shortening the economic recovery, as rising inflation or an episode of financial instability eventually causes monetary policymakers to have to act more forcefully.

https://doi.org/10.1007/s11293-018-9572-z

Published online: 12 March 2018

References

Aaronson, D., Hu, L., Seifoddini, A.. & Sullivan. D. G. (2015). Changing labor force composition and the natural rate of unemployment. Chicago Fed Letter. No. 338. Available at: https://www.chicagofed. org/publications/chicago-fed-letter/2015/338.

Blue Chip Publications (2017). Blue Chip economic indicators. Aspen Publishers. Vol. 42(12), December 10. 2017. Available at: https://lrus.wolterskluwer.com/store/blue-chip-publications/.

Federal Open Market Committee (2009-2017). Summary of Economic Projections. Available at: https://www.fedcralreservc.gov/faqs/summary-cconomic-projections-scp.htm.

Federal Reserve Bank of New York (2011-2017). Survey of Primary Dealers. Available at: https://www.ncwyorkfcd.org/markets/primarydealer_survey questions.html.

Federal Reserve Bank of Philadelphia (1996-2017). Survey of Professional Forecasters. Available at: https://www.philadelphiafed.org/rcscarch-and-data/rcal-timc-ccnter/survcy-of-professional-forecastcrs.

Rosengren, E. S. (2016). After the Great Recession, a Not-So-Great Recovery. Speech given at the 60th Federal Reserve Bank of Boston Conference, October 14, 2016. Available at https://www.bostonfed.org/newsand-events/speeches/2016/ after-the-great-recession-a-not-so-great-recovery.aspx.

(1) The views I express are my own, not necessarily those of my colleagues on the Federal Reserve Board or the Federal Open Market Committee (FOMC). This paper is an expanded version of what was given as the 2017 William S. Vickery Distinguished Address at the 84th International Atlantic Economic Conference in Montreal on Octobcr 7, 2017.

(2) That is, of the level of unemployment associated with full employment in the economy.

(3) For example, if central bankers had assumed in 2010 that the natural rate of unemployment had risen toward 9%, they would have been incorrect, as the data since then have shown.

(4) For additional perspective on the economic recovery in the wake of the financial crisis, see Rosengren (2016).

(5) A common concept of slack employed in this context is the amount of labor market slack, usually taken as the difference between the actual unemployment rate and the rate that is consistent with fall employment, called the natural rate. When unemployment is at the natural rate, the labor market docs not exert pressure to move the inflation rate away from the central bank's goal for inflation (2% in the U.S.). Thus, this definition of slack depends on obtaining an estimate of the natural rate of unemployment, a well-defined but difficult-tomeasure quantity.

(6) FOMC meeting participants (members of the Federal Reserve Board of Governors and the 12 Federal Reserve Bank Presidents) submit economic projections in conjunction with four FOMC meetings a year. A summary of these economic projections is released just prior to the press conferences (Federal Open Market Committee 2009-2017).

(7) The Survey of Professional Forecasters is a quarterly survey of macroeconomic forecasts conducted by the Federal Reserve Bank of Philadelphia (1996-2017).

(8) The New York Fed surveys primary dealers on their expectations for the economy, monetary policy and financial market developments prior to Federal Open Market Committee meetings (Federal Reserve Bank of New York 2011-2017).

(9) If the estimates from the Survey of Primary Dealers were added to the chart, the observations would be nearly superimposed on the estimates from the Survey of Professional Forecasters as they are so similar.

(10) Such movements in the estimates of an important underlying variable for measuring tightness in the labor market highlight that estimates can be too sensitive to recent underlying data. The CBO estimate of the natural rate tends to move only gradually, consistent with slow moving demographic variables, while the SEP estimates move much more. This suggests some caution in being too sensitive to incoming data relative to economic relationships that generally are believed to move only slowly.

Eric S. Rosengren [1]

[mail Eric S. Rosengren

eric.rosengren@bos.frb.org

[1] Federal Reserve Bank of Boston, Boston, MA, USA

Caption: Fig. 1 Unemployment rates in the United States, the Euro Area and Japan. Source: Bureau of Labor Statistics (BLS). Eurostat, Japan's Ministry of Health. Labor, and Welfare (MHLW), Haver Analytics

Caption: Fig. 2 Inflation rates in the United States, the Euro Area, and Japan. Source: Bureau of Economic Analysis (BEA); Eurostat; Japan's Ministry of Internal Affairs & Communications (MIC), Bank of Japan; Haver Analytics. Note: Japan's inflation scries is adjusted for an April 2014 consumption tax increase. For Japan and the Euro Area, the inflation measure is the change in the CPI. For the U.S., it is the changc in the personal consumption expenditures price index

Caption: Fig. 3 Estimates of the natural rate of unemployment. Source: FOMC. Summary of Economic Projections; CBO; Haver Analytics. Note: The central tendency excludes the three highest and three lowest observations. Prior to the June 2015 median, SEP median unemployment rates are publicly available only with a five-year lag. Proxies for the medians for 2012--March 2015 arc calculated from the distribution of participants' projections reported in ranges of tenths in the meeting minutes

Caption: Fig. 4 Share of the civilian labor force age 16 to 24 and the CBO estimate of the natural rate of unemployment. Source: BLS. CBO, Haver Analytics

Caption: Fig. 5 Share of the civilian labor force age 25 years and older, with a college degree or higher. Source: BLS, Haver Analytics

Caption: Fig. 6 Estimates of the natural rate of unemployment. Source: Federal Reserve Bank of Philadelphia, Survey of Professional Forecasters. Note: The interquartile range is the 25th--75th percentiles

Caption: Fig. 7 Estimates of the unemployment rate in the longer run. Source: Federal Reserve Bank of New York. Survey of Primary Dealers. Note: The interquartile range is the 25,h-75t,, percentiles

Caption: Fig. 8 Estimates of the natural rate of unemployment. Source: Federal Reserve Bank of Philadelphia, Survey of Professional Forecasters; FOMC, Summary of Economic Projections (SEP); CBO; Haver Analytics. Note: The central tendency excludes the three highest and three lowest observations. Prior to the June 2015 (2015:Q2) median, SEP median unemployment rates arc publicly available only with a five-year lag. Proxies for the medians for 2012-March 2015 (2015:Q1) are calculated from the distribution of participants' projections reported in ranges of tenths in the meeting minutes

Caption: Fig. 9 Actual civilian unemployment rate and estimates of the longer-run unemployment rate. Source: FOMC, Summary of Economic Projections; BLS; CBO; Haver Analytics. Prior to the June 2015 (2015:Q2) median, SEP median unemployment rates are publicly available only with a five-year lag. Proxies for the medians for 2012-March 2015 (2015:Q1) are calculated from the distribution of participants' projections reported in ranges of tenths in the meeting minutes

Caption: Fig. 10 Forecasts for the longer-run federal funds rate. Source: FOMC. Summary of Economic Projections. Note: The central tendency exclude the three highest and three lowest observations

Caption: Fig. 11 Estimates of the federal funds target rate in the longer run. Source: Federal Reserve Bank of New York, Survey of Primary Dealers. Note: The interquartile range is the 25th-75th percentiles

Caption: Fig. 12 Blue Chip Forecast for the Unemployment Rate. Source: Blue Chip Economic Indicators, December 10, 2017
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Author:Rosengren, Eric S.
Publication:Atlantic Economic Journal
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Date:Jun 1, 2018
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