Unemployment rate: How low can it go?
The unemployment rate has fallen dramatically over the last six months, but just how low can it go?
The answer is being debated among two camps of prominent economic thinkers. One school of thought says that unemployment will return to around 5% as the economy eventually recovers. But an opposing view states that permanent changes in the labor market mean higher unemployment is here to stay.
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Among those who believe the first, more optimistic scenario is Federal Reserve Chairman Ben Bernanke. He thinks that unemployment will fall as part of the regular business cycle, and stimulative policies that boost demand could bring us back to a more normal unemployment rate of between 5% and 6% some time after 2014.
There’s plenty of research to back that up. A recent report by economists at Harvard, the San Francisco Federal Reserve and the International Monetary Fund suggests that three-quarters of the sharp rise in unemployment during the financial crisis was in fact due to cyclical, not permanent, factors.
And unemployment has indeed fallen sharply as the economy has slowly recovered from the recession. As of February, the unemployment rate stood at 8.3%, a substantial drop from 10% at the height of the financial crisis…
Read nore @ Unemployment rate: How low can it go? – Apr. 4, 2012.
“… The outflows from unemployment, either into employment or out of the labor force, have been the primary determinant of unemployment rate dynamics in long expansions. The key to the importance of outflows is that within long expansions there have not been adverse shocks that lead to a burst of job losses” write Jonathan McCarthy, Simon Potter, and Ayşegül Şahin in Conclusion: How Low Will the Unemployment Rate Go? on newyorkfed.org. (Adapted excerpts by Job market Monitor)
To illustrate the power of this mechanism, were based on the movements in the outflow and inflow rates in the previous three expansions. These simulated paths show the unemployment rate declining to a level well below current consensus predictions over the medium term.
These simulations were run to their natural conclusion to see what happens to the unemployment rate if the current expansion lasts as long as any of the three most recent expansions. Recall that in these simulations, we assume that the inflow and outflow rates change at the same pace as they did in the expansions following the 1981-82, 1990-91, and 2001 recessions starting at thirty months into the expansion (roughly the point where we are now in the current expansion) through the start of the next recession (see the Okun’s Law post in this series for the length of each expansion). The simulated unemployment paths based on the three different scenarios are shown in the chart below.
The simulations demonstrate the importance of expansion length in reducing unemployment. Under the flow dynamics of the record-long 1990s expansion, the simulated unemployment rate falls to 4.7 percent, 5.3 percentage points below the peak unemployment rate observed in the recession period. For comparison, the actual unemployment rate fell to 3.9 percent in the 1990s expansion, 3.9 percentage points below its peak. The simulation using the flow rates in the 1980s expansion gives very similar dynamics: the simulated decline is 4.9 percentage points, whereas the unemployment rate actually fell 5.8 percentage points in the 1980s expansion to 5 percent. Consistent with the shorter duration of the 2000s expansion, the simulation based on the flow rates from that expansion has a minimum unemployment rate of 6 percent and the unemployment rate begins to rise toward the end of the simulation.