A 3 Handle for NAIRU

Written by Richard Hokenson 

The lack of an acceleration in wage inflation in the U.S. continues to baffle most commentators. The most recent results for the Employment Cost Index (ECI) reveals a continuation of subdued wage inflation despite or in spite of a low unemployment rate (see Chart 1). We (Hokenson & Company) have commented several times that wage inflation is low because there is more slack in the labor markets than currently perceived. A review of our past work on NAIRU (Non-Accelerating Inflation Rate of Unemployment) provides another reason. Our conclusion then that NAIRU was in the low 4’s was not optimistic enough. The share of the labor force comprised of baby boomers is larger than we thought it would be. Just as an ageing baby boom put downward pressure on the labor force participation rate, it is doing the same for the unemployment rate. It is nothing more or nothing less than mathematics. We now think that NAIRU has a 3 handle which means an even longer period of subdued wage inflation ahead of us.

As illustrated in Chart 1, the last time that the unemployment rate fell to 4.6% in 2006, wage inflation as measured by the ECI accelerated. The average unemployment rate for the first six months of this year is 4.5%. The important point to note is that 4.5% today is not the same as 4.6% was in 2006. As detailed in the Appendix, the unemployment rate is a weighted average of age-specific unemployment rates where the weights are the share of the total labor force for that age group. That is important because unemployment rates are skewed by age: highest for young workers, lower for older workers (see Chart 2). The issue that matters is whether or not an age-specific unemployment rate is above or below the total unemployment rate. A larger weight on an above-average age-specific unemployment rate results in a higher total unemployment rate. The unemployment rate, including NAIRU, is upward biased. This is what happened when baby boomers reached working age in the 1960s and 1970s and commentators then were baffled by the combination of a relatively high unemployment rate with accelerating wage and price inflation.

The opposite prevails today. Ageing baby boomers are a larger share of the labor force (see Chart 3). The ageing of the baby boom means a larger weight being multiplied by a smaller than average age-specific unemployment rate. The total unemployment rate including NAIRU is further downward biased by the fact that the share of the labor force comprised of younger persons has shrunk which means that one is multiplying a smaller weight with an aboveaverage age-specific unemployment rate (see Chart 4).

An unemployment rate below 4% is not totally uncharted territory. The last time than the unemployment rate was below 4% was 1969 (see Chart 5). But it is nearly totally if not totally unexpected. It will be very interesting to see how policy makers react. In the meantime, continued moderation in wage inflation is all the more reason to expect that the Fed will not increase interest rates this year.

The net result is an increasing armada of inflation fighters, persons who are increasingly resistant to higher prices. It helps to explain why firms find it increasingly difficult to make higher prices stick. It is also an important issue behind the bifurcation of retail trade, a topic we will discuss in a subsequent analysis.



This update was researched and written by Richard Hokenson. Data is as of 3 August 2017


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