San Francisco Fed President John C. Williams visited the Forecasters Club in New York last Thursday and gave his assessment of the economy. He named four key factors behind the slow, or "tepid" recovery: 1) the effects of the housing bubble and crash; 2) austerity measures reducing aggregate demand; 3) eroding demand for exports with a weakened global economy; and 4) unusually high levels of uncertainty. He then addressed the question of whether these factors affect supply and demand: So, is the problem today inadequate supply, or demand, or both? A useful way to think about this question is to compare the unemployment rate with the natural rate of unemployment. By the natural rate, I mean the unemployment rate that minimizes labor market imbalances and pressures—either upward or downward—on inflation. The unemployment gap—the difference between the unemployment rate and its natural rate—measures the degree to which labor demand is unequal to supply. Movements in the natural rate itself reflect changes in supply. Of course, we can’t directly measure the natural rate of unemployment. Rather, we must estimate it. This topic has appropriately garnered a great deal of attention among economists at the Federal Reserve and elsewhere in recent years. Extensive analysis of the labor market comes to a clear conclusion: Supply-side considerations explain only some of the rise in unemployment. Most of that rise is explained by a lack of labor demand. Let’s look at this more closely. Prior to the recession, a typical estimate of the natural rate of unemployment was between 4¾ and 5% (see Williams 2013). The empirical evidence suggests that the recession and policy responses to it, such as extended unemployment insurance benefits, contributed to dislocations in the labor market. These have pushed the natural rate above its pre-recession level by about 1 percentage point (see Congressional Budget Office 2013 and Daly et al. 2012b). Consistent with these findings, my estimate of the current natural rate of unemployment is about 6%, roughly 2 percentage points below the current unemployment rate. This 6% figure is consistent with many other estimates, including the most recent median estimate of the Survey of Professional Forecasters (Federal Reserve Bank of Philadelphia 2012). Fortunately, many of the influences that have elevated the natural rate of unemployment since the crisis and recession should fade over time. In fact, this process is already under way. The extended unemployment insurance programs have been scaled back and are affecting fewer and fewer people. Eventually these programs will be phased out. In addition, measures of mismatch between workers and available jobs are receding (Lazear and Spletzer 2012 and Șahin et al. 2012). And, at least so far, we are not seeing permanent scarring effects of long-term unemployment (Valletta 2013). I expect that, in coming years, the natural rate will return to a more historically typical level of about 5½%. I should note that the fact that economists are busily studying, debating, and revising their assessments of the supply side of the economy is encouraging. It makes a repetition of the mistakes of the late 1960s and 1970s much less likely. In our research, Orphanides and I found that, if economists and policymakers had similarly reevaluated their views back in the 1960s and 1970s, the stagflation of that period could have been avoided (Orphanides and Williams 2013). The conclusion that the economy is suffering primarily from weak demand rather than a shortage of supply receives additional support when the factors weighing on recovery are analyzed. The finding of the research that I mentioned on the economic effects of uncertainty—that heightened uncertainty raises unemployment and depresses inflation—is evidence that uncertainty primarily acts as a barrier to demand, not supply. Other research supports that view. In recent work published by the San Francisco Fed, Mian and Sufi (2013) compare state-level employment performance during the recession and recovery with state-level survey data from the National Federation of Independent Business. The NFIB survey asks small business owners to identify the single most important problem they face. Answers include taxes, poor sales, labor costs, government regulation, insurance costs, et cetera. Mian and Sufi find that declines in state employment were highly correlated with the percentage of respondents in each state citing lack of demand as their most important business problem. Read the full speech here .
Filed under: jobs, monetary policy, unemployment, exports, recovery, supply and demand, labor demand, causes of the crisis, Labor, San Francisco Fed, aggregate demand, federal reserve bank of san francisco, john c. williams, macroeconmic policy, macro policies, uncertainty, Forecasters Club