Natural Rate of Unemployment: Definition, Components, and Trends
Why Zero Unemployment Isn't as Good as It Sounds
The natural rate of unemployment is the lowest level that a healthy economy can sustain without creating inflation. In a healthy economy, workers are always coming and going, looking for better jobs. Until they find that new job, this jobless status considered is the natural rate of unemployment. To economists, it's a combination of frictional, structural, and surplus unemployment.
When setting interest rates, the Federal Reserve seeks to balance unemployment with growth and inflation. It uses 2% as the target inflation rate. Economists agree that the ideal gross domestic product growth rate is around 2%. The Fed does not have a specific target for unemployment. It found that employers can find innovative ways to attract workers without raising wages.
Three Components of the Natural Rate of Unemployment
Even in a healthy economy, there is some level of unemployment for three main reasons:
- Frictional Unemployment: There are always some workers who are in between jobs. Examples are new graduates looking for their first job, or workers who move to a new town without lining up another position. Some people may quit abruptly, knowing they'll get a better job shortly. Others might decide to leave the workforce for personal reasons such as retirement, pregnancy, or sickness. When they return and start looking again, the Bureau of Economic Analysis (BEA) counts them as unemployed.
- Structural Unemployment: As the economy evolves, there is an unavoidable mismatch between workers' job skills and employers' needs. It happens when workers are displaced by technology, like when automation takes over manufacturing jobs. It also occurs when factories move to cheaper locations. For example, the U.S. auto industry lost 350,000 jobs after the North American Free Trade Agreement was signed. Structural unemployment remains until workers receive new training.
- Surplus Unemployment: This occurs whenever the government intervenes with minimum wage laws or wage/price controls. It can also happen with unions because employers must pay the mandated wage while staying within their payroll budget. The only way to do this is to let some workers go. It's the consequence of an unfunded mandate.
Why You Don't Want Zero Unemployment
The only way an economy could have a 0% 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 unemployment rate recorded was 2.5% in May-June 1953. It occurred because the economy overheated during the Korean War. When this bubble burst, it kicked off the recession of 1953.
Recessions and the Natural Unemployment Rate
The natural rate of unemployment typically rises after a recession. Frictional unemployment increases once the downturn is over. Workers become confident they can quit their jobs and find a better one. Structural unemployment can also increase as the numbers of long-term unemployed rise. Their skills and experience became outdated.
The financial crisis of 2008 wiped out 8.7 million jobs and increased the unemployment rate to 10.2% in 2009. Many experts wondered if the severity of the recession would contribute to a higher natural rate of unemployment.
The Cleveland Federal Reserve found that the recession shifted the natural rate a bit higher, but less so than expected given its severity. Long-term trends that drive down the rate of natural unemployment outweighed the short-term impact of the recession.
The natural rate of unemployment has been declining since the 1980s. One reason is that the percentage of older workers (age 55 and over) has increased, from 12.7% in 1999 to 23.4% in 2019. Older workers who lose their jobs are more likely to retire and leave the labor force instead of adding to unemployment levels.
The Cleveland Fed also noted that "job polarization" has shifted the labor force into either low-skill or high-skill occupations. The middle-skill occupations have been replaced by technology, while high-skill workers are less likely to be laid off, which lowers the natural unemployment rate.
- The natural rate of unemployment is the lowest level that a healthy economy can sustain without creating inflation.
- Zero unemployment is unattainable because employers would raise wages first.
- Natural unemployment contains three components: structural unemployment, surplus unemployment, and frictional unemployment.
- The 2008 recession did not offset the long-term trends that are lowering the U.S. natural rate of unemployment.