Here’s why the NY fed says unemployment could go lower than anyone expects

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Economists at the NY Fed have come up with an alternative to the standard Okun’s Law that sees the unemployment rate falling well below consensus.

Where Okun’s Law relates unemployment to GDP, their “bathtub model” emphasizes the importance of outflows from unemployment.

These outflows will increase thanks to (1) acquisition of skills to meet new employment demands; (2) decreasing numbers of long-term unemployed; (3) unemployed people who decide not to re-enter the market—notably Baby Boomers and women.

As long as the economy keeps expanding, these trends will steadily bring down the unemployment rate to 6.5 percent by 2014 and as low as 4.7 percent by 2018.

Economists Jonathan McCarthy, Simon Potter and Ayşegül Şahin admit that, yes, their outlook may seem optimistic:

This series of labor market posts has examined the possible paths of the unemployment rate if the current expansion lasts beyond the postwar average of fifty-nine months. Of course, readers of this post may consider the assumption that the current expansion will last at least until mid-2014 as optimistic. However, once one assumes an ongoing expansion, then it seems likely that the unemployment rate will continue to fall more quickly than predicted by consensus forecasts based on a moderate growth outlook. Whether or not this fall in the unemployment rate produces fast overall growth in the economy depends on the speed at which the employment-to-population ratio increases and the productivity of the workers added as the labor market expands. The flow-based approach we have taken to study the labor market appears superior to the more aggregate approach taken by many forecasters using Okun’s Law. Moreover, even though flow rates have declined in recent years, the U.S. labor market remains dynamic by international standards. By examining flows as well as stocks in the labor market, we come to conclusions that differ from the conventional wisdom about how difficult it might be to reduce so-called structural unemployment, as we showed in our analysis of unemployed construction workers.

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