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FRBSF Economic Letter

1997-35 | November 21, 1997
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NAIRU: Is It Useful for Monetary Policy?
John Judd

Forecasting

Problems with the NAIRU

Is there a better way?

Conclusions

References

In recent years, a debate has re-emerged about whether the Federal Reserve
should pay attention to the “NAIRU” in conducting monetary policy. NAIRU is an
acronym for “non-accelerating-in ation rate of unemployment” (a closely related
concept is the “natural rate of unemployment”). The NAIRU gures prominently in
the Phillips curve, which is a relationship that incorporates a temporary trade-off
between the unemployment rate and in ation. According to the Phillips curve, an
unemployment rate that is below the level identi ed as the NAIRU (that is, a “tight”
labor market) tends to be associated with an increase in in ation; conversely, an
unemployment rate that is above the NAIRU tends to be associated with a
decrease in in ation. It is well known that the trade-off between in ation and
unemployment is only temporary and cannot be systematically exploited by
monetary policies aimed at permanently lowering the unemployment rate. In the
long run, attempts to do so end up generating higher in ation with no
improvement in unemployment. However, the Phillips curve also implies that
demand-induced changes in in ation tend to lag behind movements in the
unemployment rate, which means that a comparison between the actual
unemployment rate and the NAIRU may be helpful in forecasting future changes
in in ation.

Tight labor (and product) markets were one reason for the Fed’s “preemptive
strike” against in ation in 1994 (see Judd and Trehan 1995). The federal funds
rate was raised from 3% in early 1994 to 6% in early 1995 without actual increases
in broad measures of in ation, like the CPI. This action was explained as a
response to indications that in ation would rise in the future without policy action.
Over the past year, however, the funds rate has not been raised despite a fall in the
unemployment rate to 4-3/4% – 5, below most estimates of the NAIRU. Some
people have argued that policy action should be taken to prevent an upward creep
in in ation, while others have asserted that there is no in ation threat on the
horizon.

These recent experiences have stimulated the current debate about the NAIRU,
with some economists arguing that it provides useful information for monetary
policy and others arguing that it is dangerously misleading (Journal of Economic
Perspectives 1997). This Letter discusses the key elements in this controversy.

Forecasting

The lags in monetary policy present a problem for central banks, because a policy
action taken today may not affect in ation for a year or two. Therefore, in
attempting to control in ation, it is dangerous to look only at current rates of
in ation. By the time in ation actually begins to rise, in ationary pressures may
have been brewing for a year or two, and it may take a substantial tightening of
policy (possibly leading to a recession) to head them off. The lag in policy
explains why most central banks expend considerable effort in forecasting future
economic developments. In fact, some central banks (for example, those in the
United Kingdom, Canada, and New Zealand) use publicly announced forecasts as
a key element in the formulation of their policies.

According to models of the economy that incorporate a Phillips curve, the

unemployment rate plays a role in the transmission process from unanticipated
changes in the aggregate demand for goods and services (called “demand
shocks”) to in ation. In these models, increases in demand raise real GDP relative
to its potential level, which increases the demand for labor to produce the
additional goods and services, and therefore lowers the unemployment rate
relative to the NAIRU. Excess demand in goods and labor markets leads to higher
in ation in goods prices and wages with a lag. Because of this, the unemployment
rate can help in generating the in ation forecasts that are crucial in formulating
monetary policy.

Problems with the NAIRU

Critics of using the NAIRU concept to guide policy raise both empirical and
theoretical arguments. On the empirical side, they point out that the estimated
NAIRU for the U.S. has varied in the postwar period. In the 1960s, the NAIRU
commonly was estimated at around 5%. By the mid-1970s, it had climbed to
around 7%. And by the mid-1990s, it had fallen back to 5 1/2 to 6% (Staiger, Stock,
and Watson 1997). A number of factors can affect the NAIRU, including changes
in labor force demographics, governmental unemployment programs, and
regional economic disturbances.

A related empirical criticism is that the NAIRU cannot be estimated with much
precision. Based upon comprehensive empirical analysis of Phillips curves,
Staiger, Stock, and Watson conclude that their best tting equation yields a 95%
probability that the NAIRU falls within a range of 4.8 to 6.6%. Given this kind of
uncertainty, the NAIRU can provide misleading signals for monetary policy at
various times.

A theoretical objection to the use of the NAIRU for monetary policy is that the
short-run trade-off between unemployment and in ation may be unstable over
time. This trade-off is sensitive to the way in which expectations about in ation
are formed, which in turn will depend upon the nature of the monetary policy
regime itself. As noted above, for example, any trade-off would tend to disappear
if a central bank attempted to exploit it systematically.

A further theoretic objection –one which has been discussed a lot recently–is that
the NAIRU makes sense as an indicator of future in ation only when the economy
is hit with demand shocks, like those described above for the Phillips curve model
(Judd and Trehan 1990 and Chang 1997). However, the economy also may be
affected by supply shocks, or unexpected changes in the aggregate supply of
goods and services. An example of a supply shock would be a sudden increase in
productivity. Initially, this kind of shock would raise the quantity of goods and
services produced relative to the quantity demanded, and thus put downward
pressure on prices. At the same time, the increase in real GDP would raise the
demand for labor and reduce the unemployment rate. Thus, a falling
unemployment rate would be associated with reduced pressure on prices. If a
central bank were using the NAIRU to guide policy in this case, it might mistakenly
see the lower unemployment rate as a reason to fear higher in ation in the future,
and therefore might tighten policy.

Some observers argue that a supply shock is currently having an effect on the
economy. Over the past couple of years, real GDP has increased rapidly, and the
unemployment rate has fallen to a low rate of 4 3/4% – 5%, while in ation has
come down a bit. Therefore, standard Phillips curves have over-forecasted
in ation recently, although the errors generally have not been outside the
historical range of errors. One explanation offered for recent developments is a
surge in productivity due to the introduction of new computer-related
technologies. While it is still too soon to know for sure what is driving recent
developments, the possibility of a supply shock has to be taken seriously. This
possibility illustrates the pitfalls in interpreting the implications of the
unemployment rate for future in ation. At the same time, however, it is too soon
to be sure that the current low level of the unemployment rate does not presage a
rise in in ation in the future.

Is there a better way?

The arguments presented above have been used to criticize what could be called
a “trigger” strategy, in which the central bank would compare the unemployment
rate to the latest estimate of the NAIRU and change the funds rate according to
whether in ation was predicted to rise or fall in the future. This criticism of such a
trigger strategy is well founded. However, it is doubtful that any central bank
would base policy on such a simple response to any single variable.

A more relevant question is how forecasting models that incorporate the NAIRU
concept perform relative to alternative models. Since all forecasting models are
subject to error, the practical issue for central banks is which type of model
provides the best forecasts. In other words, it is not enough to show that the
NAIRU-based models are subject to error. It is also necessary to show that the
uncertainties associated with them are bigger than those of alternative models.

The alternative models that have been used for this purpose include monetarist
models that rely mainly on a measure of the money supply to forecast in ation,
and vector autoregressions (VARs) that produce purely statistical forecasts
without relying on any theory concerning what causes in ation. Both of these
alternatives have drawbacks.

Since in ation is a monetary phenomenon, monetary models have an obvious

theoretical advantage in forecasting in ation. However, the empirical problems
with the monetary aggregates over the past 15 to 20 years are well known. In the
early 1980s the Fed relied heavily on M1, a narrow aggregate; by the mid-1980s,
however, M1’s relationship with real GDP and in ation became too uncertain, and
the Fed de-emphasized it in favor of the broader aggregates, M2 and M3. These
aggregates retained some reliability until the 1990s when they began to
experience serious problems. The main di culty with all of these aggregates
appears to have been the deregulation of the nancial system in the 1970s and
1980s and the rapid nancial innovation that has been going on in the U.S. and
world economies for the past two decades or so. These di culties help explain
the results of studies by Stockton and Struckmeyer (1989) and Tallman (1995),
which have found forecasting advantages with Phillips curve models compared
with monetarist models, although both approaches involved considerable
uncertainty.
With regard to VARs, it is well known that they do a good job of forecasting real
GDP, but have more problems forecasting in ation (McNees 1986). The reliability
of VARs appears to be particularly vulnerable to major changes in in ation
regimes, such as the ones in the U.S. in the 1960s and late 1970s (Webb 1995).

Conclusions

Models that can forecast in ation are valuable to central bankers because
monetary policy actions affect in ation with a lag. Models that incorporate a
NAIRU concept have problems as forecasting devices, especially if the economy
is hit with a supply shock. The current situation may be an example of such a
case. Recent forecast errors, though not especially large by historical standards,
nonetheless may provide a rationale for some de-emphasis of the unemployment
rate in policy deliberations. However, it is not clear that monetary models or VARs
provide superior alternatives to NAIRU-based models. This consideration may
help to explain the continued use of NAIRU-based models by many policymakers,
despite well-known conceptual and empirical shortcomings.

As economists continue to work on these problems, advances in modeling may

provide better alternatives. For example, Chang suggests that models along the
lines of those developed by Bernanke (1986), which explicitly attempt to
decompose relevant data into demand and supply shocks, might be useful. An
important test of the usefulness of such models for monetary policy would be
whether they offer advantages in forecasting in ation.

John P. Judd
Vice President and Associate Director of Research

References

Bernanke, Ben S. 1986. “Alternative Explanations of the Money-Income

Correlation.” Carnegie-Rochester Conference Series on Public Policy pp. 49-99.

Chang, Roberto. 1997. “Is Low Unemployment In ationary?” Federal Reserve Bank
of Atlanta Economic Review, First Quarter, pp. 4-13.

Journal of Economic Perspectives. 1997. “Symposium: The Natural Rate of

Unemployment” (Winter) pp. 3-108.
Judd, John P., and Bharat Trehan. 1995. “Has the Fed Gotten Tougher on
In ation?” FRBSF Economic Letter No. 95-13 (March 31).

_______, and ______. 1990. “What Does Unemployment Tell Us about Future
In ation?” Federal Reserve Bank of San Francisco Economic Review (Summer) pp.
20-37.

McNees, S. K. 1986. “The Accuracy of Two Forecasting Techniques: Some

Evidence and an Interpretation.” New England Economic Review (March) pp. 20-31.

Staiger, Douglas, James H. Stock, and Mark W. Watson. 1997. “The NAIRU,
Unemployment and Monetary Policy.” Journal of Economic Perspectives (Winter)
pp. 33-49.

Stockton, David J., and Charles S. Struckmeyer. 1989. “Tests of the Speci cation
and Predictive Accuracy of Nonnested Models of In ation.” Review of Economics
and Statistics pp. 275-283.

Tallman, Ellis W. 1995. “In ation and In ation Forecasting: An Introduction.”

Federal Reserve Bank of Atlanta Economic Review (January/February) pp. 13-27.

Webb, Roy H. 1995. “In ation Forecasts from VAR Models.” Journal of Forecasting
pp. 267-285.

Opinions expressed in FRBSF Economic Letter do not necessarily re ect the views
of the management of the Federal Reserve Bank of San Francisco or of the Board
of Governors of the Federal Reserve System. This publication is edited by Sam
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