Yellen and the Labor Market

In her first testimony as Fed chair, Janet Yellen said — as we all hoped and expected she would — that she doesn’t believe that the conventional unemployment rate gives a good picture of the amount of labor market slack. She mentioned, in particular, the high level of long-term unemployment and the large number of involuntary part-time workers.

Indeed. Here’s a quick and dirty exercise which I’m sure has been done at the Fed and elsewhere. Compare the usually cited unemployment rate (U3) with the broadest definition, U6, a definition that includes discouraged and involuntary part-time workers. Since U6 data begin in 1994, it looks like this:

The blue dots are for the period before the Great Recession, the red dots for later observations, and I show the latest month. Historically, U3 and U6 have moved very much together. But currently U6 is higher than you would have expected given the decline in U3; if the pre-GR relationship still held, you wouldn’t expect U6 to be this high unless the narrower definition of unemployment was at 7.5 percent.

So which is the right measure, in the sense of giving a better picture of labor market slack? We won’t know that until or unless labor markets get strong enough that wage growth begins to accelerate.

The policy implications are, however, quite clear, because the risks are asymmetric. If the Fed were to tighten soon because it thought we were nearing full employment, and it turned out to be wrong, we would be well on the way to a permanent low-inflation or even deflation trap. If it waits, inflation might tick up a bit before it sees that it has overshot, but since there are good reasons to raise the inflation target anyway, that’s not a scary prospect.

So damn the U3; full speed ahead.

via:http://krugman.blogs.nytimes.com/2014/02/11/yellen-and-the-labor-market/