Long-Run Trends and the Natural Rate of Unemployment.

• Author: Sahin, Aysegul
• Position: Research Summaries

Starting with Milton Friedman and Edmund Phelps, academics and policymakers have endeavored to measure a sustainable level of unemployment and the implications that deviations from this level have for inflation of prices and wages. This natural rate of unemployment, u*, is broadly defined as the unemployment rate at which, controlling for supply shocks, inflation remains stable.

Long-run trends in the labor market and changes in inflation expectations make it hard to pin down this natural rate of unemployment. Specifically, the dramatic trend decline in unemployment and the concurrent anchoring of inflation expectations since the 1980s have triggered extensive discussions in policy and academic circles. My recent work focuses on using detailed data on labor market flows and inflation expectations to estimate the natural rate of unemployment.

In this report, I first focus on the drivers of the trend decline in unemployment and review my work that connected this decline to two prominent long-run trends in the economy: the grand gender convergence and the dual aging of workers and firms. Then I summarize my work and discuss a unified framework that I have developed with Richard Crump, Stefano Eusepi, and Marc Giannoni for estimating the natural rate of unemployment. While I mostly focus on the period before the COVID-19 pandemic, I end with a discussion of the effect of the pandemic on the natural rate of unemployment.

Trend Decline in the Unemployment Rate

A useful insight from my research with Michael Elsby and Bart Hobijn is that the flow origins of unemployment rate movements provide useful information about the underlying drivers of unemployment fluctuations and trends. (1) The idea is simple: the unemployment rate increases either because more workers become unemployed (inflows increase) or it becomes harder for the unemployed to leave unemployment (outflows decrease). Visual examination of inflow and outflow rates in Figure 1 shows that the inflow rate is characterized by sharp, short-lived spikes during recessions, while the outflow rate from unemployment is strongly procyclical with persistent downswings during recessions. The figure also shows the secular trends in these flow rates, estimated using flow data by detailed demographics with a state-space method that I developed with Crump, Eusepi, and Giannoni. (2) The two flows that shape the evolution of the unemployment rate over time exhibit differential long-run trends. The inflow rate has a striking downward trend declining gradually to 0.02, with half of its level preceding the twin recessions of the early 1980s. In contrast, there is no evident trending behavior in the outflow rate.

This stark decline in the rate at which workers become unemployed caused about a 1 percentage point decline from the 1980s to the 1990s and another 1.5 percentage point decline from the 1990s to 2020 in the long-term trend rate of unemployment...