To those outside the world of finance, the word nairu might be mistaken for a late sixties fashion statement. But in the tongue of bankers, especially those at the Federal Reserve, the term is much more complicated and because of that, the subject of increasing debate.

An acronym for non-accelerating inflation rate of employment, nairu is closely watched for signs of change. The Fed believes that if employment reaches a certain level, employers will be forced to raise wages to attract new employees. It will never reach zero of full employment however because of business ebbs and flows and the presence of disabled and/or disparaged workers.

They also believe when employers begin to raise the level of pay, this additional cost will not result in a parallel increase in productivity.

Because of these higher wage costs, businesses will be forced to raise prices for the consumer creating inflation where none existed. A balance between these forces, employment, productivity and inflation is what the F.O.M.C has tried so hard to accomplish with the short-term overnight rate.

Now Nairu is coming under closer scrutiny in the Bernanke Fed. Nairu, generally represented by the actual unemployment rate is merely a forecast and because the committee is made up of numerous fed governors, the consensus rules over a single voice. 

In a previously issued opinion, the Fed saw an increase in inflation as the direct result of lower unemployment with a forecasting a range of unemployment between 4.5% and 5%.  Now, the Fed has shifted their thinking somewhat suggesting that there is no magic Nairu number that will force inflation to move significantly.

Two things might undermine that thinking. The first comes from an unexpected increase in resource utilization.  The cost of energy and raw materials could push inflation higher without changing unemployment significantly.  Even with some commodities selling off their 2006 highs, the very real possibility that they have reached a bottom already this year worries both Bernanke and businesses.

The second involves perception. The public generally sees inflation as a report of “the here and now”.  ut it is in fact a snapshot of what has been. Should unemployment drop and subsequently push inflation up, the Fed would not have as much in the way of reaction time. Once unemployment/inflation reach certain levels, it can be doubly difficult to get it back down using interest rates alone. A move in the overnight rate can alter perception in the near term but in reality, interest rate shifts take months to work their way into the economy.

Fortunately, Bernanke has a weakening economy on his side. Housing has softened considerably, manufacturing has seen a drop-off capacity, and the consumer has remained willing to buy at a better-than-expected rate. Cold weather in the east will likely help ease any pressure by pushing the unemployment rate higher.

Bernanke can rest assured that he has little to do but wait. The markets can anticipate a year with the rate remaining steady at 5.25%. Decoupling unemployment and inflation will give the Fed a little more wiggle room.  But just how much room will be needed should the economy weaken further remains to be seen.

Determining the natural rate of unemployment changes from decade to decade. In the nineties, the natural rate was 6.2%. Economists now believe that the rate in this decade would be closer to 5.5%, well above the current unemployment rate. Inflation is above the previously acknowledged Fed target of 2%. By those measures alone, inflation is already at work in this economy.

The only question that remains: what additional information needs to surface before the Fed changes their current stand on rates? If he focuses on prices, he might not be able to control the accompanying change in the unemployment rate. If he doesn’t do anything, suggesting that the two no longer correlate, the soft landing that everyone has hoped for will be much harder.

© 2007 Paul Petillo
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