The ‘Output Gap” explained

I have being going over the theory behind the output gap and here is an explanation – written a few years ago. Probably not so applicable to the economic environment today

Just as Messrs Friedman and Phelps had predicted, the level of inflation associated with a given level of unemployment rose through the 1970s, and policymakers had to abandon the Phillips curve. Today there is a broad consensus that monetary policy should focus on holding down inflation. But this does not mean, as is often claimed, that central banks are “inflation nutters”, cruelly indifferent towards unemployment.

If there is no long-term trade-off, low inflation does not permanently choke growth. Moreover, by keeping inflation low and stable, a central bank, in effect, stabilises output and jobs. In the graph below the straight line represents the growth in output that the economy can sustain over the long run; the wavy line represents actual output. When the economy is producing below potential (ie, unemployment is above the NAIRU), at point A, inflation will fall until the “output gap” is eliminated. When output is above potential, at point B, inflation will rise for as long as demand is above capacity. If inflation is falling (point A), then a central bank will cut interest rates, helping to boost growth in output and jobs; when inflation is rising (point B), it will raise interest rates, dampening down growth. Thus if monetary policy focuses on keeping inflation low and stable, it will automatically help to stabilise employment and growth.

New Zealand’s NAIRU

Stephen Toplis at the BNZ produced an interesting graph showing the Non Accelerating Inflation Rate of Unemployment – NAIRU. With the increasing amount of structural unemployment in the New Zealand economy caused by a mismatch – Skills of unemployed v Skills required in the labour market – the NAIRU is around 5%. This means that an unemployment level of 6.7% is worringly tight and a level below 5% could be inflationary. This is likely to result in upward pressure on wages which will erode corporate profitability given that output growth will be constrained.

NZ Unemployment up but is it all bad?

Although the recent figures for the rate of unemployment in New Zealand have increased from 6.4% to 6.7% there are some interesting statistics with regards to participation rates and employment rates.

The employment rate increased 64.2% of the total working-age population, from 63.9%. The BNZ highlighted the following:

1. The unemployment rate hasn’t been affected too greatly during the last 4 years as NZ nears the bottom of the economic cycle;
2. NZ employment rate has settled well above that seen following the 1998 recession and significantly above that which was experienced following the early-1990s recession;
3. New Zealand’s early-1990s employment rate is about where a lot of the troubled developed-world economies now find themselves – Greece, Spain, and even the US. See graph below;
4. New Zealand, in contrast now has one of the highest employment rates in the world (testimony to its relatively high participation rate, coupled with a high rate of placement into jobs).

With firms indicating that it is their intention to take on more staff the BNZ estimate that the unemployment rate will be:

6.2% Dec 2012
5.6% Dec 2013

One wonders where the NAIRU is? The rate of unemployment when inflation is stable – maybe 4%. This is much lower than that of the US – see Beveridge Curve postings

Higher natural rate of unemployment will mean structural reforms

The recent special report in The Economist looked at the altering structure of the labour market worldwide. Obviously globalisation and technology have brought big changes in the nature of work, and levels of unemployment will remain high in the developed world as developing countries see their numbers employed being boosted.

Edmund Phelps, Nobel Economist, thinks that the US natural rate of unemployment in the medium term is realistically around 7.5% which is significantly higher than a few years ago. Remember the natural rate occurs when inflation is correctly anticipated – this level of unemployment results when the economy is at full employment.

Michael Spence, another Nobel prize-winning economist, agrees that technology is hitting jobs in America and other rich countries, but argues that globalisation is the more potent factor. Some 98% of the 27m net new jobs created in America between 1990 and 2008 were in the non-tradable sector of the economy, which remains relatively untouched by globalisation, and especially in government and health care. Lowering this natural rate will require the following:

1. changing education to ensure that people enter work equipped with the sort of skills required so that there is no mismatch
2. adjusting the tax system – incentivise work
3. modernising the welfare safety net – encourage those to find work
4. encourage entrepreneurship and innovation.

This is easier said than done.

Long-Term Unemployment
This has increased dramatically in many countries – 58% in Ireland, 40% in both Spain and Japan, and 30% in the US, see graph below.

The concern with these figures is that the longer poeple are out of work the less likely there are able to find future employment. There are two reasons for this:

1. Their skills get out-dated very quickly and this is especially prevalent in the current labour market as technology is starting to takeover many procedural white-collar jobs.
2. Motivationally they find it hard to engage in the process of lookign for work and this is esepecially prevalent once a person is on a generous welfare benefit.

According to The Economist:
Long-term unemployment often turns into permanent unemployment, so governments should aim to keep people in work, even if that sometimes means continuing to pay them benefits as they work.

New Zealand’s NAIRU and youth unemployment

The BNZ Economy Watch today talked of the labour market pressures that might be facing New Zealand over the next year – this is especially prevalent if the country is going to meet the needs of a more bouyant economy. What is interesting to notice is the actual unemployment figures during the recent recession compared with those from earlier downturns:

2010 – Unemployment 7%
1998 – Unemployment 7.9%
1991 – Unemployment 11.2%

This suggest that in 2010 the labour was already very tight going into the recession and had fallen to 3.4% which is well below what is considered New Zealand’s NAIRU (Non-Accelerating Inflation Rate of Unemployment) of 5.0% – earlier this year I did a post on the Austalian NAIRU – Aussies – cruising along nicely but watch for the NAIRU. So it could be said that the first stages of the recession were just reducing the excess demand in the labour market and even when in recession employers reported difficulties in finding skilled labour. See graph below

The BNZ is concerned that the labour supply is insufficient and has the potential to result in a combination of constrained economic expansion, rising unit labour costs and increasing inflationary pressures more generally.

Youth Unemployment
The current youth unemployment rate (those aged 15 to 19) is a staggering 27.5%. Moreover, the next age group up (ages 20 to 24) has an unemployment rate of 13.5%. See graph at the bottom of the post.

If the youth unemployed are the main pool of labour available to call on for economic growth then there may be issues in finding the necessary skills. At that point, however, the data becomes “curiouser and curiouser” when one looks even more closely at its composition. Despite the relative surge in the youth unemployment rate the proportion of unemployed who are youths actually falls. What this means is that youth employment fell and rather than unemployment rising folk simply left the labour force altogether. And boy did employment fall. Stephen Toplis BNZ

Inflation outlook
The labour market still appears to be very tight and this will ultimately lower New Zealand’s growth potential. This means that lower growth rates will impact on inflationary pressures as labour becomes more scarce and therefore this may lead to an increase in interest rates and the NZ$. Not really what New Zealand needs at this present time.

OCR stays at 2.5% but Bollard warns of hikes to come.

As on expectations the RBNZ held the OCR at 2.5% today. However Alan Bollard did suggest that tightening is anticipated in December but don’t be surprised if it is a 50 basis points increase as the bank is wary of inflationary expectations. The cash rate is expected to peak at 4.75% by the end of 2012 which means a further increase by 175 basis points.

According to the Bank of New Zealand the RBNZ’s inflation view are weighted to the upside. In particular, we note that “the Bank’s policy outlook relies on three key assumptions.
These are that:
- construction cost inflation will be subdued relative to its mid 2000s peak;
- households will continue to focus on reducing debt;
- recent increases in surveyed inflation expectations will be short lived”.

However, the labour market is also worthy of note. The Reserve Bank is forecasting the unemployment rate to fall to 4.5% which one would suspect is below or close to the non-accelerating inflation rate of unemployment – NAIRU. This could add inflationary pressures to the economy. According to Stephen Toplis of the BNZ:

Moreover, the RBNZ falls into the trap of assuming that the current 6.6% unemployment rate will act to suppress inflation near term. But this misses the point that the current youth (those aged 15 to 19) unemployment rate is 27.5%! The next age group is high too. The current unemployment rate of those aged 25 and over is just 4.6%. This is the group from which most skilled labour comes from. It is stretched already so we believe the risk of wage inflation is probably higher than the RBNZ expects.

Aussies – cruising along nicely but watch for the NAIRU

Although aggregate demand in the Australian economy is currently a little subdued the Reserve Bank of Australia seem to have plenty of ammunition available for stimulatory purposes. With the cash rate being 4.75% (see graph below) it could be said that the RBA are ahead of the play with regard to rate increases. The labour market appears to be strong and the terrible events in Japan will no doubt lead to a surge of commodity demand as rebulding and reconstruction proceeds. With this in mind there is the chance of capacity constraints and therefore investment in the mining and related industries will be essential. In the year the RBA will need to be aware of demand pressures as the economy puts its foot on the gas once again. With this expected growth and boost to employment figures the RBA will weary of the Australian NAIRU (see previous post – Australia’s NAIRU) and will want this unemployment figure to drop at a very slowly rate as inflationary issues could become prevalent. The Treasury estimate for the NAIRU (also know as the Full Employment range) is between 4.5% and 5% – see graph below.

So, while Wall Street became fixated by sub-prime mortgages and collateralised debt obligations, Australia concentrated on its natural endowments. Remember Australia never went through an official recession during the finanacial crisis.

Reserve Bank of Australia – Cash Rate


Unemployment and the NAIRU

NZ unemployment up to 6.8%

The pick-up in unemployment, which was above RBNZ expectations, should indicate that Alan Bollard will wait for a more robust rebound in the economy before tightening monetary policy. The indications are that he will wait till September before implementing contractionary measures. Commentators are optimistic in the long-run as, eventhough the unemployment figures are disappointing, some surveys are promising:

- business and consumer surveys are solid from 2010
- expectations about hiring in the labour market are positive

What is worrying is that wage and salary inflation is on the up, with unit labour costs running near 2% per annum, and nominal rates pushing 4%. Even with this level of unemployment one wonders what is the NAIRU – the non-acclerating inflation rate of unemployment. During the upturn economists looked at 5% being the rate at which unemployment didn’t impact on prices. These figures also suggests that we have some structural unemploymnet issues and a mismatch between vacant jobs and the skills of the unemployed.

Australia’s NAIRU

NAIRU – non-accelerating inflation rate of unemployment – is part of the CIE A2 course and below is a look at how it might affect the Australian economy and explanation of the theory.

While the US economy appears to be in danger of slipping into a double-dip recession and sovereign debt risks casts a shadow over Europe, the Australian economy powers on. The reason for this is the country’s biggest resources boom in more than a century. Perhaps the challenge of managing Australia’s economic success will turn out to be more difficult than steering the economy through the financial crisis. If economic growth picks up to 4% in the coming years, which is above the annual average rate, this will lead to serious capacity constraints and the economy would be heading towards full employment. With unemployment very close to 5% which Treasury estimates is Australia’s NAIRU – non-accelerating inflation rate of unemployment – a measure used to gauge when labour shortages start to feed into wage and inflation pressures. This would then threaten the RBA’s target band for inflation (2-3%) and lead to higher interest rates which would hurt those sectors of the economy that haven’t been a part of the commodity boom from China.

Explaining the NAIRU
Bill Phillips (of Phillips Curve fame) discovered a stable relationship between the rate of inflation (of wages, to be precise) and unemployment in Britain from the 1850′s to 1960′s. Higher inflation, it seemed, went with lower unemployment. To economists and policymakers this presented a tempting trade-off: lower unemployment could be bought at the price of a bit more inflation. However, Milton Friedman and Edmund Phelps (who both later picked up Nobel prizes, partly for this work), pointed out that the trade-off was only temporary. In his version, Friedman coined the idea of the “natural” rate of unemployment – the rate that the economy would come up with if left to itself. Now economists are likelier to refer to the NAIRU (non-accelerating inflation rate of unemployment), the rate at which inflation remains constant. The theory is explained below:

Suppose that at first unemployment is at the NAIRU, u* in the graph below, and inflation is at p0. Policymakers want to reduce unemployment, so they loosen monetary policy: that stimulates spending, so that unemployment goes down, to u1. Inflation rises to p1, along the initial short-run Phillips curve, PC1. But that raises inflationary expectations, so that workers demand higher wage increases and real wages rise again. Firms shed labour, returning unemployment to u*, but with a higher inflation rate, p1. The new short-run trade-off is worse, with higher inflation for any level of unemployment (PC2). In the long run the Phillips curve is vertical (LRPC).