For years, Fed watchers have been getting antsy as unemployment falls toward the central bank’s estimate of the non-accelerating inflation rate of unemployment, or NAIRU. NAIRU is what the Federal Reserve uses to estimate how low the unemployment rate can get before inflation rises. However, as shown in the graphic below, each time unemployment has threatened to break through the NAIRU, the Federal Reserve has lowered its estimate of NAIRU rather than raise interest rates. Why?
The answer would appear to be in wage growth. As shown in the small inset graph, there is a strong relationship between wage growth and slack in the labor market — as measured by the difference between the unemployment rate and the Fed’s NAIRU estimate. What this suggests is that the Fed has consistently overestimated wage growth, leading it to lower its NAIRU estimate when new wage data come out.
As the yellow highlighted part of the graphic shows, we appear to be at a turning point. Wage growth was strong over the second half of last year, leading the Fed to leave NAIRU estimates unchanged as the unemployment rate continued to fall. That rate is now near the bottom of the Fed’s NAIRU range. This supports the case for the Fed to hike interest rates.
But beware. Though the Atlanta Fed measure of wage growth remains strong at around 3.5 percent, wage growth slowed last month. Falling wage growth could continue as previously discouraged workers return to the job market, increasing the labor supply and thus reducing pressure on employers for higher pay.
Should wage growth fall to 2.5 percent, we can, on past experience, expect the Fed to lower NAIRU again, such that its measure of labor market slack rises from zero to as much as 0.8 percentage points. If that happens, the Fed will put interest rate hikes on hold.