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Don't settle for new 'natural' jobless rate of 7 per cent

There’s no reason for us to be satisfied with a ‘natural’ unemployment rate of 7 per cent, but long-term reductions in unemployment are less a matter of stimulating demand than of improving the functioning of the labour market.

matthew sherwood The Globe and Mail

The unemployment rate for December was 7.5 per cent. For many people, the end of the recession will occur when things go back to where they were back in 2007-08: somewhere around 6 per cent. That's almost certainly too much to hope for.



According to the Bank of Canada's revised projection released yesterday, the "output gap" -- the difference between actual GDP and the Bank's estimate of potential output -- will close sometime in the latter half of next year. As it is, GDP was only 0.7 per cent below potential in the third quarter of 2011, so the economy is about four-fifths of the way out of the recession hole.



But an output gap of zero is not where we started from. One of the reasons the recession was so sharp is that it started when the economy was booming: GDP went from being 1.7 per cent above potential in the third quarter of 2008 to 3.3 per cent below in the second quarter of 2009.

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The accompanying chart shows that there's a fairly strong negative correlation between the output gap and the unemployment rate (the output gap axis is reversed). Unemployment rates less than 7 per cent are generally observed when GDP is at least one percentage point above potential, and the pre-recession unemployment rate of 6 per cent was attained after a stretch of more than a year in which output was 2 per cent above capacity.





So the levels of employment and unemployment we saw in 2007-08 shouldn't be used as a baseline for what is 'normal'. Looking at that graph, a plausible estimate for the unemployment rate associated with potential output is probably around 7 per cent or so. (The Conference Board of Canada's projection for 2013 is 6.8 per cent.)



The policy challenge during recessions is to stimulate demand in order to return output and employment back to potential, and this has been the priority of fiscal and monetary policy for the last three years.



But when output reaches capacity, the set of appropriate policy instruments will change. There's no reason for us to be satisfied with a 'natural' unemployment rate of 7 per cent, but long-term reductions in unemployment are less a matter of stimulating demand than of improving the functioning of the labour market. We're going to have to start thinking about a different set of employment-related questions fairly soon.





Stephen Gordon's recent posts and Twitterfeed can be viewed here.



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About the Author

Stephen Gordon is a professor of economics at Laval University in Quebec City and a fellow of the Centre interuniversitaire sur le risque, les politiques économiques et l'emploi (CIRPÉE). He also maintains the economics blog Worthwhile Canadian Initiative. More

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