CBO’s Unnatural Estimates of the Natural Rate of Unemployment

October 21, 2015

CEPR

Nicolas Buffie

In recent months, members of the Federal Reserve (“Fed”) have been weighting the idea of raising interest rates. This is a tremendously important decision that can affect the labor market prospects for thousands or even millions of workers.

Some members of the Fed have been citing the low unemployment rate, which fell to 5.14 percent last quarter, as the main impetus for raising rates. These members argue that the labor market is nearing the “non-accelerating inflation rate of unemployment,” (NAIRU) at which unemployment becomes so low that it triggers accelerating inflation.

However, if the NAIRU is even lower than 5 percent, then a decision to raise interest rates based on a mistaken estimate of the NAIRU would needlessly throw many Americans out of work.

The drop in the estimates of the NAIRU from the Congressional Budget Office (CBO) should give us some cause for concern. The table below shows the history of CBO NAIRU estimates since the start of 2012.

Quarter	CBO Estimates
Quarter	January 2012	August 2012	February 2013	February 2014	August 2014	January 2015	August 2015
2012 Q1	5.50	5.30	5.50	5.30	5.30	5.30	5.27
2012 Q2	5.50	5.32	5.50	5.32	5.32	5.32	5.26
2012 Q3	5.50	5.36	5.50	5.36	5.36	5.36	5.24
2012 Q4	5.50	5.40	5.50	5.39	5.39	5.39	5.22
2013 Q1	5.50	5.44	5.50	5.42	5.42	5.42	5.20
2013 Q2	5.50	5.50	5.50	5.45	5.45	5.45	5.18
2013 Q3	5.50	5.48	5.50	5.48	5.48	5.48	5.16
2013 Q4	5.50	5.50	5.50	5.50	5.50	5.50	5.14
2014 Q1	5.50	5.50	5.50	5.50	5.50	5.50	5.12
2014 Q2	5.50	5.50	5.50	5.50	5.50	5.47	5.10
2014 Q3	5.50	5.50	5.50	5.50	5.50	5.44	5.09
2014 Q4	5.50	5.50	5.50	5.50	5.50	5.40	5.08
2015 Q1	5.50	5.50	5.50	5.50	5.49	5.39	5.07
2015 Q2	5.50	5.50	5.50	5.50	5.49	5.38	5.06
2015 Q3*	5.50	5.50	5.50	5.50	5.48	5.38	5.06
2015 Q4	5.50	5.50	5.50	5.50	5.48	5.37	5.05
2016 Q1	5.50	5.50	5.50	5.50	5.47	5.36	5.04
2016 Q2	5.50	5.50	5.50	5.50	5.46	5.35	5.03
2016 Q3	5.50	5.50	5.50	5.50	5.46	5.35	5.03
Source: St. Louis Federal Reserve, Archival Economic Data. *Last quarter. The unemployment rate was 5.14 percent during the third quarter of 2015.

Why has CBO continuously marked down its estimates? The answer seems to be that unemployment keeps coming down more quickly than CBO anticipated, yet there hasn’t been any rising inflation. The graph below compares the unemployment rate to CBO’s estimated natural rate of unemployment at the time, and shows how much higher CBO’s current estimates would be if they hadn’t revised their figures down:

CBO's Downward Revisions to the Natural Rate of Unemployment

The CBO estimates of the NAIRU for the second half of 2015 have fallen by 0.44 percentage points over this period. Had the Fed raised interest rates to keep unemployment at 5.50 percent, there would have been an additional 563,000 unemployed Americans in the third quarter of 2015. Even using the more recent January 2015 CBO estimate of 5.38 percent would have resulted in an additional 375,000 jobless workers.

This downward trend in estimates of the NAIRU is due to the fact that inflation has not followed the path predicted based on the unemployment rate. As a result CBO has lowered its estimates of the NAIRU. Presumably the Fed has followed a similar course with its own estimates of NAIRU. Perhaps at some point inflation will again follow the path predicted by the unemployment rate, but it has not recently, and if the Fed had been basing policy on the CBO’s estimates of NAIRU, it would have needlessly been keeping hundreds of thousands of people out of work. Furthermore, it would be denying tens of millions of people the bargaining power they need to secure wage gains.