The U.S. economic recovery still has a lot of upside

Are we nearing full employment and will the Fed soon be tightening policy? The government’s latest employment report was the best in many years. Payroll employment rose by over a million during the past three months, with strong job gains in the preliminary data for January and large upward revisions in the previous estimates for November and December. Based on this surge in labor input, it is a good bet that the preliminary estimate of the fourth quarter’s GDP will be revised upward as well.

A stronger expansion has been the aim of policy since the Great Recession. Now that it seems well established, policymakers and markets will increase their focus on how much more potential upside there is. If employment is closer to full employment, then policymakers may be tightening sooner than previously expected, and financial markets will anticipate such an earlier response.

But there is a big complication to this story. While there is broad agreement that there is a full employment range, empirical estimates of the unemployment rate at full employment and of how much employment can grow before that point is reached are very unreliable. Rather than flashing an early warning sign about overheating the economy, the strong recent data may show the economy can expand more than previously thought. After all, because the stronger jobs market brought previously discouraged workers into the work force, the unemployment rate in January was still 5.7 percent, the same as the average of the previous three months.

The standard empirical model of full employment presumes to identify the lowest unemployment rate that can be sustained without accelerating inflation (which gives rise to the acronym NAIRU). It was first used to explain the 1970s, a period of persistent inflation fueled by a history of tight wartime labor markets, huge inflationary shocks from oil prices, and powerful unions and other institutions that perpetuated shocks through a tight wage-price spiral. Today’s economy bears no resemblance to that one, but data from that period still influence attempts to estimate where full employment is today. Many such estimates identified the inflation danger point as 6 percent unemployment, meaning we should have slowed the economy some time ago. And estimates confined to data from more recent decades provide no useful estimates because inflation has been too tranquil.

But if formal modelling is not helpful, a simpler look at the past quarter century is instructive. In the two previous economic expansions, the unemployment rates averaged 5.6 percent and 5.3 percent and reached lows of 3.8 percent and 4.4 percent. And in neither case did low unemployment become an inflation problem. The 1991-2000 expansion started with a 5.1 percent (12 month) core CPI inflation rate; that declined to an average core inflation rate of 2.9 percent over the long expansion that followed. In the 2002-2007 expansion, the core inflation rate averaged 2.1 percent and peaked at 2.8 percent. Not only does this experience suggest unemployment can safely go well below present levels, but it shows no evidence that a little inflation is dangerous because it quickly accelerates. It does not.

Janet Yellen and her colleagues know all this and much more. They know that while rapid inflation is a problem that can be costly to undo, a little inflation is a good thing. They are trying to achieve faster growth of wages as a feature of a healthier labor market, and that means welcoming a slightly higher rate of price inflation. And they know that the composition of the labor force may affect what full employment target is feasible, with mature workers likely to be more attached to their jobs than younger workers. For all these reasons, rather than trying to estimate an unemployment target for policy, they are likely to look mainly at inflation in deciding on policy changes.

Because keeping the policy interest rate at zero has taken on such symbolic meaning, the Fed may soon move up the rate in light of the more robust recovery. But such a move should not be interpreted as the first of a series of tightening steps that would meaningfully slow the expansion or level off the unemployment rate. And that means the economy is still only in the middle of what should be an extended period of good growth and rising employment.