Low Inflation at "Essentially Full Employment"

Yesterday, Brad Delong took issue with Charles Evans' recent claim that "Today, we have essentially returned to full employment in the U.S." Evans, President of the Federal Reserve Bank of Chicago and a member of the FOMC, was speaking before the Bank of Japan Institute for Monetary and Economic Studies in Tokyo on "lessons learned and challenges ahead" in monetary policy. Delong points out that the age 25-54 employment-to-population ratio in the United States of 78.5% is low by historical standards and given social and demographic trends.

Evans' claim that the U.S. has returned to full employment is followed by his comment that "Unfortunately, low inflation has been more stubborn, being slower to return to our objective. From 2009 to the present, core PCE inflation, which strips out the volatile food and energy components, has underrun 2% and often by substantial amounts." Delong asks,

And why the puzzlement at the failure of core inflation to rise to 2%? That is a puzzle only if you assume that you know with certainty that the unemployment rate is the right variable to put on the right hand side of the Phillips Curve. If you say that the right variable is equal to some combination with weight λ on prime-age employment-to-population and weight 1-λ on the unemployment rate, then there is no puzzle—there is simply information about what the current value of λ is.

It is not totally obvious why prime-age employment-to-population should drive inflation distinctly from unemployment--that is, why Delong's λ should not be zero, as in the standard Phillips Curve. Note that the employment-to-population ratio grows with the labor force participation rate (LFPR) and declines with the unemployment rate. Typically, labor force participation is mostly acyclical: its longer run trends dwarf any movements at the business cycle frequency (see graph below). So in a normal recession, the decline in the employment-to-population ratio is mostly attributable to the rise in the unemployment rate, not the fall in LFPR (so it shouldn't really matter if you simply impose λ=0).

https://fred.stlouisfed.org/series/LNS11300060

As Christopher Erceg and Andrew Levin explain, a recession of moderate size and severity does not prompt many departures from the labor market, but long recessions can produce quite pronounced declines in labor force participation. In their model, this gradual response of labor force participation to the unemployment rate arises from high adjustment costs of moving in and out of the formal labor market. But the Great Recession was protracted enough to lead people to leave the labor force despite the adjustment costs. According to their analysis:

cyclical factors can fully account for the post-2007 decline of 1.5 percentage points in the LFPR for prime-age adults (i.e., 25–54 years old). We define the labor force participation gap as the deviation of the LFPR from its potential path implied by demographic and structural considerations, and we find that as of mid-2013 this gap stood at around 2%. Indeed, our analysis suggests that the labor force gap and the unemployment gap each accounts for roughly half of the current employment gap, that is, the shortfall of the employment-to-population rate from its precrisis trend.

Erceg and Levin discuss their results in the context of the Phillips Curve, noting that "a large negative participation gap induces labor force participants to reduce their wage demands, although our calibration implies that the participation gap has less influence than the unemployment rate quantitatively." This means that both unemployment and labor force participation enter the right hand side of the Phillips Curve (and Delong's λ is nonzero), so if a deep recession leaves the LFPR (and, accordingly, the employment-to-population ratio) low even as unemployment returns to its natural rate, inflation will still remain low.

Erceg and Levin also discuss implications for monetary policy design, considering the consequences of responding to the cyclical component of the LFPR in addition to the unemployment rate.

We use our model to analyze the implications of alternative monetary policy strategies against the backdrop of a deep recession that leaves the LFPR well below its longer run potential level. Specifically, we compare a noninertial Taylor rule, which responds to inflation and the unemployment gap to an augmented rule that also responds to the participation gap. In the simulations, the zero lower bound precludes the central bank from lowering policy rates enough to offset the aggregate demand shock for some time, producing a deep recession; once the shock dies away sufficiently, policy responds according to the Taylor rule. A key result of our analysis is that monetary policy can induce a more rapid closure of the participation gap through allowing the unemployment rate to fall below its longrun natural rate. Quite intuitively, keeping unemployment persistently low draws cyclical nonparticipants back into labor force more quickly. Given that the cyclical nonparticipants exert some downward pressure on inflation, some undershooting of the long-run natural rate actually turns out to be consistent with keeping inflation stable in our model.

While the authors don't explicitly use the phrase "full employment," their paper does provide a rationale for the low core inflation we're experiencing despite low unemployment. Erceg and Levin's paper was published in the Journal of Money, Credit, and Banking in 2014; ungated working paper versions from 2013 are available here.