Natural Rate of Unemployment, Its Components, and Recent Trends

Why zero unemployment isn't as good as it sounds

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The natural rate of unemployment is a combination of frictional, structural, and surplus unemployment. Even a healthy economy will have this level of unemployment because workers are always coming and going, looking for better jobs. This jobless status, until they find that new job, is the natural rate of unemployment. 

The Federal Reserve estimates this rate to be between 4.5 percent and 5.0 percent. Both fiscal and monetary policymakers use that rate as the goal for a full employment. They use 2 percent as the target inflation rate. They also consider the ideal GDP growth rate to between 2 percent and 3 percent. They must try to balance these three goals when setting interest rates, tax rates, or spending levels.

Three Components of the Natural Rate of Unemployment

Even in a healthy economy, there is some level of unemployment for three reasons.

  1.  Frictional Unemployment – Some workers are in between jobs. Examples are new graduates looking for their first job. Others are workers who move to a new town without lining up another job. Some people quit abruptly, knowing they'll get a better job shortly. Still, others might decide to leave the workforce for personal reasons such as retirement, pregnancy or sickness. They drop out of the labor force. When they return and start looking again, they're counted as unemployed.
  2.  Structural Unemployment – As the economy evolves, there is an unavoidable mismatch between workers' job skills and employers' needs. This happens when workers are displaced by technology, as when robots take over manufacturing jobs. It also occurs when factories move to cheaper locations, as happened when NAFTA was signed. When baby boomers reached their 30s and had fewer children, there was less need for daycare workers. Structural unemployment remains until workers are retrained.
  1. Surplus Unemployment – This occurs whenever the government intervenes with minimum wage laws or wage/price controls. It can also happen with unions. When wages are reset to a higher level, unemployment often results. Why? To keep within the same payroll budget, the company must let go of some workers to pay the remaining workers the mandated higher salary.

In addition, there are six dangerous types of unemployment. They are cyclical, long-term, real, seasonal, classical, and underemployment.

Why You Don't Want Zero Unemployment

The only way an economy could have a zero percent unemployment rate is if it is severely overheated. Even then, wages would probably rise before unemployment fell to absolute zero.

The United States has never experienced zero unemployment. The lowest rate was 2.5 percent, in May and June 1953. That's only because the economy overheated due to the Korean War. When this bubble burst, it kicked off the Recession of 1953.

The Recession Could Have, But Didn't, Raise the Natural Rate of Unemployment

The financial crisis of 2008 wiped out a staggering 8.3 million jobs. The unemployment rate rose from 4.7 percent to 10.1 percent at its peak in 2009. This huge loss meant that many of the unemployed stayed that way for six months or more. Long-term unemployment made it even more difficult for them to get back to work. Their skills and experience became outdated.

Does this mean that the recession would leave, as its legacy, a higher natural rate of unemployment? Research done by the Cleveland Federal Reserve said yes, this could be the case. That's because job turnover slowed. Throughout the recession, those with jobs were less likely to leave them. In fact, by 2011, those leaving jobs (the separation rate) was as low as it was during the boom before the recession. 

The reasons were different though. During the boom, people didn't leave jobs. They liked them and were paid well. Employers had a difficult time finding new employees, so they made sure workers were happy. During the recession, workers were afraid to leave and look for better employment. They put up with long hours and no raises just to keep their jobs.

The natural rate of unemployment typically rises after a recession. Frictional unemployment increases since workers can finally quit their jobs, confident they can find a better one now that the recession is over. In addition, structural unemployment is higher, since workers have been unemployed for so long their skills no longer match the needs of businesses. 

Between 2009 and 2012, the natural rate of unemployment rose from 4.9 percent to 5.5 percent. That was higher than during the recession itself. Researchers grew concerned that the length and depth of the recession meant the natural rate would remain elevated. But by 2014, it had fallen to 4.8 percent. (Source: "Natural Rate of Unemployment," St. Louis Federal Reserve, March 22, 2017.)​