The Fed and unemployment

Posted: Aug 21, 2000 12:00 AM
One of the hottest issues in economics today is something with the odd name of NAIRU, which stands for non-accelerating inflation rate of unemployment. The idea behind NAIRU is that there is a level of unemployment that is consistent with stable inflation. Any fall in unemployment below that level runs the risk of causing inflation to rise. NAIRU is important because the Federal Reserve lives by it. If it believes that the current rate of unemployment is below NAIRU, it will keep monetary policy tight and interest rates high in order to forestall inflation. There are many problems with the NAIRU concept. But one of the most important is that no one really knows what it is. It is not calculated on a monthly basis, like the official unemployment rate, and can only be estimated after the fact. Yet the Federal Reserve takes policy actions based on NAIRU that affect the economy today. Press reports indicate that the Fed puts NAIRU at between 5 percent and 5.25 percent presently. With unemployment at 4 percent, this suggests that current unemployment is in the inflationary range. That explains why the Fed has been raising interest rates despite the lack of inflation in the Consumer Price Index. The idea behind NAIRU is that there are structural factors in the economy that prevent unemployment from ever falling to zero or even close to it. Even in a full-employment economy there will always be frictional unemployment resulting from people quitting jobs or natural restructuring of the economy, as jobs shift from slow growing sectors to fast growing sectors. In the 19th century, for example, vast numbers of workers shifted from agriculture to manufacturing, causing temporary unemployment as the shift occurred. The great economist Irving Fisher was the first to suggest NAIRU. In a 1926 article in the International Labor Review, he noticed that changes in prices tended to forecast changes in employment. Thirty-two years later, British economist A.W. Phillips reversed the relationship, indicating that changes in unemployment forecast changes in inflation. Henceforth, this relationship became codified as the Phillips Curve, which shows that low unemployment causes inflation. This would be a matter of purely academic interest except that the Federal Reserve treats NAIRU as gospel truth, tightening monetary policy whenever the unemployment rate falls. Chief among the Fed's inflation hawks is Governor Lawrence H. Meyer, who obsesses about the low unemployment rate and its inflationary potential. Apparently, he has many allies on the Federal Reserve's Open Market Committee, which meets tomorrow and may once again raise interest rates in response to low unemployment. Leaving aside theoretical objections to the NAIRU concept that have been leveled by economists such as Milton Friedman, it is worth looking at the factors that constitute NAIRU. A new study by Federal Reserve economist Peter Tulip is instructive. His research shows that for quite some time the largest single component of the NAIRU has been the minimum wage. The minimum wage raises the NAIRU because it puts a floor under wages, preventing them from falling, regardless of economic conditions. No matter how high the unemployment rate is or how low market wage rates may fall, the minimum wage mandates that workers must be paid a minimum of $5.15 per hour. And this rate applies only to cash wages, regardless of how large a worker's benefits might be. Increases in the minimum wage also tend to push up the wages of workers whose wages are just above the new minimum. Higher wage costs force employers to raise prices, thereby contributing to inflation. Tulip concludes that a 10 percent rise in the minimum wage raises the NAIRU by about half a percentage point. Legislated increases in the minimum wage in the 1960s and 1970s were the largest factors in the rise of NAIRU, causing it to almost double. By the late 1960s, the minimum wage was responsible for more than half of the NAIRU. When Ronald Reagan became president in 1981, he put a stop to rises in the minimum wage. He understood that a higher minimum wage made the job of reducing inflation more difficult and also raised unemployment. Thus, although a small number of workers might be helped by a higher minimum wage, many, many more were hurt. Freezing the nominal (money) value of the minimum wage during the 1980s caused its real value to steadily decline. The result was a concomitant fall in the NAIRU from more than 7 percent in 1980 to less than 5 percent by the end of the decade, according to Tulip. The decline in the NAIRU allowed the Fed to ease monetary policy without fear of reigniting inflation, contributing to strong growth in the 1980s. Unfortunately, George Bush caved-in to congressional demands to raise the minimum wage, contributing to the Fed's tight money policy in the early 1990s. Increases in the minimum wage imposed by Bill Clinton are also causing the NAIRU to rise and forcing the Fed to tighten monetary policy. Since monetary policy has a far greater impact on economic growth and unemployment -- and hence the well-being of workers -- than does the minimum wage, this suggests that raising the minimum wage is, at best, a Pyrrhic victory for them.