Analysis: There's no reason unemployment can't go under 4 percent


The Federal Reserve has ones of the best problems it could right now: Inflation isn't supposed to be this low when unemployment is this low as well.

It's pretty simple. When almost everyone who wants a job has one, companies have to compete over workers by offering them higher pay. Which, if it goes on long enough, will eat into their profits enough that they have to raise prices too. Wage inflation, in other words, will eventually turn into price inflation. It's an apparent trade-off between unemployment and inflation that economists call the Phillips curve.

But it's not happening now. The economy just added 261,000 jobs in October, 90,000 more than we had previously thought in the months before, and saw the unemployment rate fall to a new 17-year low of 4.1 percent - and yet wages have still only risen a relatively anemic 2.4 percent the past year. They don't show any signs of accelerating either.

Now, as Nick Bunker of the left-leaning Washington Center for Equitable Growth points out, that might just be due to the fact that the labor market isn't nearly as strong as the 4.1 percent unemployment rate would lead you to believe.

The share of 25 to 54 year-olds who should be in the prime of their working years and are also, in fact, working is well below the all-time peak it set in 2001, or even the pre-recession one in 2007. It's only about 80 percent of the way back to where it was then. Which is to say that, even eight years into the recovery, there still appears to be plenty of what's called "shadow slack": people who want to work, but aren't officially unemployed, since they've given up looking for now. That, more than anything else, might explain why workers don't seem to have the bargaining power you'd expect with joblessness at its lowest level since President Bill Clinton was in the White House.

If this is right, wages just need more time for more people to get back to work. After that, they'll go up.

The thing is, though, it might not even matter if they do. After all, it's been awhile since wage inflation has turned into price inflation the way the Phillips curve tells us it should. In fact, there's basically no relationship between the two today. Since 1994, wage growth only "explains" about 2 percent of core inflation; between 1965 and 1994, it was 56 percent.

What in the name of Econ 101 is going on? Well, nobody knows for sure, but it seems like a pretty big coincidence that wage growth stopped turning into anything other than 2 percent inflation right after the Fed started unofficially targeting, you guessed it, 2 percent inflation. It might be that companies are more willing to accept lower profit margins when they know for a fact that the alternative is higher interest rates. Especially when they know that the decline of unions and the threat of outsourcing have made worker bargaining power an ephemeral thing. Better to wait out wage demands that might only hurt in the short-run than to raise prices and invite interest rate hikes that might hurt for even longer.

But this is almost besides the point right now. Whether wage growth is low because there's still a fair amount of slack or won't push inflation up even if it's high, the conclusion is the same for the Fed: Don't pull the plug on the recovery by raising rates too soon. They can afford to be even more patient than they already are, and let unemployment fall even further than they thought possible.

Like I said, it's the best kind of problem. It's solved by doing nothing.

By Matt O'Brien. O'Brien is a reporter for Wonkblog covering economic affairs. He was previously a senior associate editor at The Atlantic.