In the mid- to late-1990s, when I had been at the Chicago Fed for only a short time, one of the big questions was whether inflation would increase given the tightening labor market. The unemployment rate had fallen from 7-3/4 percent in 1992 to 5-1/2 percent in early 1995. Conventional thinking at the time was that the natural rate of unemployment was around six percent. So when unemployment went below that six percent level, a number of people worried that accelerating inflation was just around the corner...  Most analysts have since revised their estimates of the natural unemployment rate, putting it in the range of five percent.

...Demographic changes also are a factor in the decline in the natural rate of unemployment. As the baby boom generation acquired more working experience, their ability to find jobs improved. It happens to every generation. Experienced workers have more employable skills, know more about what jobs match their skills, and have built a broader network to help them conduct a job search. Since 1960, the unemployment rate for 25-34 year olds has been about two percentage points higher than the unemployment rate for 45-54 year olds, on average. In the late 1980s, about 15 percent of the labor force was 45-54. This share has since trended up and now appears to be peaking at 23 percent. In turn, the natural rate of unemployment for the entire economy should be lower because of the relatively higher employability of these workers, who now constitute a larger portion of the workforce.

For example, the civilian unemployment rate dropped by 1 percentage point to 4.6 percent in September. This rate is a bit lower than conventional estimates of so-called "full employment" and, therefore, suggests that by now labor markets may even have moved a bit to the tight side.

Most forecasters believe that growth slowed further in the third quarter because of another decline in residential investment and more moderate business investment in structures and inventories....

While hiring has slowed, the unemployment rate was quite low in August at 4.7% of the labor force.  This unemployment rate is below the level that many economists believe is consistent with full employment and stable prices. 

Indeed, the unemployment rate dropped by about three-fourths of a percentage point, coming in at 4¾ percent in August {2006}.  This rate is actually a little bit lower than conventional estimates of so-called "full employment," and therefore suggests that there may be some tightness in labor markets.

The econometric calculations behind the Phillips curve, capacity constraints and output gaps were based on assumptions of a world that, in my opinion, no longer exists.

I like to look at the inflation directly rather than the unemployment rate. If you look at a chart that plots unemployment rate or changes in unemployment rate against inflation there is only the very, very weakest of relationships there. It's just not an adequate indicator for monetary policy purposes in the short run.

The unemployment rate has fallen to 5 percent; at the Chicago Fed, we think that this rate is roughly consistent with an economy operating at potential.

Academic research has shown that estimates of NAIRU are very imprecise and are subject to significant standard deviations…My own research department estimated that the NAIRU was between 3.4 and 5.9 percent between 1983 and 2004 with a 95 percent confidence level. This is a fairly wide band of uncertainty. The problem is that estimates with this level of imprecision are of limited use when conducting monetary policy. When policymakers are attempting to evaluate whether there is still slack in the labor market, or if any further decrease in unemployment may lead to inflationary pressures, it clearly would be preferable to have more precise estimates of NAIRU.

The natural rate of unemployment is probably better thought of as a zone rather than as a single number, however. In particular, inflation does not appear to rise sharply or discontinuously when the economy reaches a specific rate of unemployment or capacity utilization but instead responds more gradually to variations in the degree of resource utilization (in economics lingo, the Phillips curve is fairly flat).

We were motivated, in part, by the view that the evident structural economic changes rendered suspect, at best, the prevailing notion in the early 1990s of an elevated and reasonably stable NAIRU. Those views were reinforced as inflation continued to fall in the context of a declining unemployment rate that by 2000 had dipped below 4 percent in the United States for the first time in three decades.

The Communist Manifesto exults over the "specter haunting Europe"--the growth of communism. America's ability to grow in a socially equitable manner confronts a serious threat from another economic theory, one that shares with Marx's construct its devotees' loyalty in the face of strong contradictory evidence. This danger can be even more appropriately labeled a specter because, unlike Marx's hope that his newborn would grow rapidly, we are menaced by the revivification of a theory from a recent inglorious demise.

I refer to the return of the NAIRU. The concept known as the "nonaccelerating inflation rate of unemployment," or NAIRU, holds that there is a point below which unemployment cannot fall without triggering economy-destroying inflation. Well into the 1990s, the theory was widely supported by mainstream economists, whose consensus pegged the NAIRU threshold at roughly 6 percent. Should unemployment fall below that magic number, the financial establishment preached, unacceptable inflation would be set in motion--and thus the authorities, particularly the Federal Reserve system, had to be ready to slow down economic activity once unemployment dropped below the NAIRU.

But in the mid-1990s, a funny thing happened to the NAIRU: It shrank rapidly. And ultimately the shrinkage was so inexplicable that the idea became intellectually and politically insupportable.

I think we soon ought to consider putting at least one nail in the NAIRU coffin. Not only has the economy failed to perform according to that framework in the last five or six years but, so far as I'm aware, going back 15 or 16 years there just is no evidence of an empirical relation between labor market conditions and inflation.

I doubt we’d be worried very much at all about inflation if it weren't for what I'll call NAIRU guilt pangs. Estimates of the NAIRU have always been weak econometrically in the sense of having high standard errors. Moreover, point estimates of NAIRU are bound to be reduced the longer the economy goes without accelerating inflation. We are now nearing the end of the fourth year where the unemployment rate is less than the conventional estimates of NAIRU, with very little evidence of accelerating inflation. Sure, there have been special factors, such as the rise in the dollar and the productivity shock. But as time goes on, I still become less and less convinced that unemployment is below the imperfectly estimated NAIRU level.

We cannot yet be sure that the slower expansion of domestic final demand, at a pace more in line with potential supply, will persist. Even if the growth rates of demand and potential supply move into better balance, there is still uncertainty about whether the current level of labor resource utilization can be maintained without generating increased cost and price pressures. As I have already noted, to date costs have been held in check by productivity gains. But at the same time, inflation has picked up--even the core measures that do not include energy prices directly. Higher rates of core inflation may mostly reflect the indirect effects of energy prices, but the Federal Reserve will need to be alert to the risks that high levels of resource utilization may put upward pressure on inflation.

I would remind you that in the 20 years prior to this recent episode, the Phillips curve based on NAIRU was probably the single most reliable component of any large-scale forecasting model. It was very useful in understanding the inflation episode over that entire period. Certainly, there is greater uncertainty today about where NAIRU is, but I would be very cautious about prematurely burying the concept.