Question:
Since the end of World War 2, annual unemployment rates in America have largely ranged between 4 and 6%. It has hit double digits only once and has dropped below 3% only once. Unemployment has averaged 5.5% over that time, with a standard deviation of 0.016. A lot has happened over those 80 years. Union Membership grew to 35% and has fallen back to 10%. OSHA was formed. The EPA was formed. America shifted from a largely 1 income household to a 2 income household. Automation has been introduced. Entire industries have been created, collapsed, or both. Why is the unemployment rate so stable? and why does is stay around 5.5%?Answer:
This is a terrific question, one that has been addressed in various ways by at least 5 Nobel Laureates: Milton Friedman, Edmund Phelps, Peter Diamond, Dale Mortensen, and Christopher Pissarides. Friedman and Phelps explained that unemployment rates tended toward an equilibrium natural rate. Trying to lower unemployment rates below the natural rate through government spending or artificially low interest rates would only be temporarily successful and would create inflationary pressure. Diamond, Mortenson and Pissarides showed that job vacancies and job seekers coexist because of frictions in the labor market that prevent all job seekers from instantly finding the available jobs.
Think of our national labor market as a giant game of musical shares. Every month, some jobs disappear due to firm closings, falling demand for some products, or changes in input availability or production processes. At the same time, new jobs are created as firms enter, new products are developed, or some products experience rising consumer demand. The people seeking jobs cannot instantaneously find the available jobs because the chairs that are taken away are not in the same places as the chairs that are added. Even if the number of job vacancies is equal to the number of job seekers, there will be unemployment due to the delay in the seekers finding the available vacancies. This type of unemployment is called the natural rate or the equilibrium rate of unemployment. It has also been called the NAIRU: the non-accelerating inflation rate of unemployment: the unemployment rate that will not lead to rising inflation rates.
In the graph below, I show the data on the actual unemployment rate and the estimated natural unemployment rate since 1970. The actual unemployment rate varies considerably over time. It has been below 5.5% for the last five years since the second quarter of 2021. It has exceeded 10% three times since 1970. When the actual rate is below the natural rate, we have had inflationary pressures, most notably in the 1970s and the post-pandemic recovery.
To your question, the natural rate of unemployment is quite stable. The actual unemployment rate shows considerable persistence (called hysteresis) but gradually approaches the natural rate.
Source: Author’s calculations based on the actual unemployment data compiled by the U.S. Bureau of Labor Statistics and the natural unemployment rate compiled by the U.S. Congressional Budget Office. Both the series were downloaded from the Federal Reserve Bank of St. Louis data base available at https://fred.stlouisfed.org
