Unemployment Set to Improve, But Only So Much

The jobless rate's "natural" set point is significantly higher than it was pre-recession.

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As long as unemployment is above 6.5 percent and inflation is stays below 2.5 percent, the Federal Reserve suggested it will keep interest rates near zero.

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"Good, but not good enough" has become the unofficial slogan of the post-recession jobs recovery. The unemployment rate is at 7.8 percent—down from its post-recession high of 10 percent in October 2009, but far above what would be comfortable. The current recovery is, by a long shot, the slowest post-recession jobs recovery since World War II. And even if job growth accelerates, the jobless rate may not be able to sink to pre-recession levels.

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The unemployment rate's "natural" threshold is significantly higher than it was prior to the recession. The CBO currently says the natural rate of unemployment is around 5.5 percent, up from its 5 percent level where it stood from 2000 through the start of 2009. That means even if demand were healthy and Americans decided to open their wallets, the job market would hit equilibrium—or the stable point of where it "wants" to be—at 5.5 percent and fluctuate around that point. In other words, the level of what is "normal" employment has shifted upward.

Some economists put that level even higher. A recent Philadelphia Federal Reserve survey of economists found that, on average, they put the natural rate of unemployment at nearly 6 percent.

According to another expert's calculations, this 6 percent figure sounds accurate.

"There's an increase of about 1 percent in the non-accelerating inflation rate of unemployment. So it's around 6 percent rather than 5 percent," says William Dickens, professor of economics and social policy at Northeastern University and former senior economist for Bill Clinton's Council of Economic Advisers.

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This "non-accelerating rate" is known by economists as the NAIRU. It's a relatively obscure bit of economic jargon, but some economists see it as one measure of the natural unemployment rate. The idea is that below a particular unemployment rate, inflation starts to speed up. So by Dickens' reckoning, rising prices could become a worry as unemployment edges toward 6 percent.

Why?

To put it simply, when unemployment gets low enough, companies start competing more for workers, rather than vice versa. Firms, in turn, offer higher salaries and, knowing they can compete well in the job market, workers can demand more money. As wages increase across the board, so does inflation.

That has implications for Fed policy. Recently, the Federal Reserve indicated it would likely keep interest rates near zero in order to stimulate the economy as long as unemployment is above 6.5 percent and inflation is no more than 2.5 percent. But if inflation should accelerate as the jobless rate approaches 6.5 percent, Ben Bernanke and his colleagues will have to reassess.

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Clearly the job market is a long way from hitting these invisible "natural" barriers, but they signal that significant factors other than a lack of demand are keeping the jobless rate above the 5 percent region where it tended to hang in the mid-2000s. Still, there's no reason to think that underlying rates will stay high forever.

"[Unemployment benefits] were larger, more generous than usual, and they still are, and they are going to gradually decline. Eventually they will return to pre-recession levels. That is something that increases the natural rate of unemployment." says Gad Levanon, director of macroeconomic research at the Conference Board, pointing to the emergency unemployment benefits enacted to cope with the massive job losses experienced due to the recent economic crisis.

Dickens also says some new economic research suggests aggressive action from both Congress and the Federal Reserve could help the country bust through this sort of unemployment rate force field (and eventually drag it downward), but it would mean going through a painful period of higher inflation.

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Either way, Levanon stresses that even if the job market's equilibrium point is higher now, it's not a permanent change.