Hysteresis and Monetary Policy

Chairman Bernanke and Vice Chair Yellen have recently talked about hysteresis.

• In reference to labor markets, hysteresis is the process whereby cyclical unemployment becomes structural unemployment.
• Since the Great Recession, there have been discussions about hysteresis and other possible sources of a rise in structural unemployment in the U.S.
• Higher structural unemployment would, of course, translate into a higher NAIRU, and, if we fail to account for this, we could mismeasure the amount of slack and, therefore, the threat of inflation.

Previous empirical evidence suggests that hysteresis is a property of labor markets in Europe, not in the U.S., but this may be changing.

• The empirical evidence has linked hysteresis to institutional aspects of the labor market. In the U.S., relative to Europe, fewer workers belong to unions, labor markets are more flexible, and the matching of job vacancies and job seekers is more efficient.
• But one worrisome feature of U.S. labor markets after the Great Recession is that the ranks of the long-term unemployed (those who have been jobless for 27 weeks or more) has risen to a record high relative to the total pool of unemployed workers.
• Long spells in unemployment can lead to eroded skills and, thus, less employability, even after the economy picks up. This could be an important source of hysteresis.
• We interpret the remarks by the Chairman and the Vice Chair as reflecting concerns about potential hysteresis and, thus, supporting the current highly accommodative policy stance. We didn't read them as suggesting the need for additional accommodation.

On the whole, we see concern about the threat of hysteresis as reinforcing the need to maintain the current highly accommodative stance of monetary policy, rather than justifying further monetary policy stimulus. As a result, despite the recent concern voiced by the Chairman and Vice Chair about the threat of hysteresis, we have not changed our FOMC call: no funds rate hikes until at least late 2014 and no QE3.

Hysteresis is a source of structural unemployment that is longer-lived, and, therefore, may affect the NAIRU for a very long time. The long-run NAIRU is the minimum sustainable unemployment rate in the long run, that is, the lowest unemployment rate consistent with stable inflation in the long run. Previous empirical studies have uniformly supported the view that hysteresis is a property of European but not U.S. labor markets. But this time may be different! Hysteresis seems most likely to arise when long-duration unemployment is especially high, as has been the case in the U.S. since the Great Recession.

An important question for the U.S. economy is whether hysteresis is just a threat or has already taken place, raising the long-run NAIRU. On the surface, the evolution of FOMC participants' forecasts suggests that hysteresis may already have reached U.S. shores. The FOMC regularly provides its estimates of the long-run NAIRU, at least implicitly. Those estimates have trended upward since their initial publication in 2009, rising from 5.1% in 2009 to 5.5% today. The FOMC doesn't call these forecasts estimates the NAIRU-some don't even believe that there is a NAIRU-but, in effect, that's how we see them.

The failure to clearly distinguish the 6%-to-7% estimate of the short-run NAIRU from the 5.2%-to-6% central tendency range of FOMC participants' estimates of the long-run NAIRU-their forecasts of the unemployment rate in the long run-has needlessly created confusion. Alas, given the subtlety of the distinction between the short- and long-run NAIRUs, some confusion may be inevitable. The remainder may reflect other temporary factors, such as less efficient matching of the unemployed with vacancies. All three components of structural unemployment-extended benefits, less efficient matching, and hysteresis-raise both the actual unemployment rate and the (short-run) NAIRU. Therefore, they do not affect the gap. This is a reason why the decline in the unemployment rate through 2014 in our forecast (and also the FOMC's) does not put upward pressure on inflation. That is, much of this decline reflects diminishing structural unemployment, not a decline in cyclical unemployment.

Chairman Bernanke recently voiced concern about the prospect of hysteresis in the U.S. More recently, Vice Chair Yellen also raised concern about hysteresis. The comments by the Chairman and Vice Chair suggest that the threat of hysteresis supports the FOMC's current policy stance, though not necessarily the need for additional accommodation. Indeed, we read those remarks as consistent with our view that the first rate hike is still a long way away (late 2014) and that current conditions do not justify QE3. 

Our conclusion, like that of the Chairman and Vice Chair, is that there is, as yet, no definitive evidence that hysteresis has raised the NAIRU. While monetary policy should be more aggressive in the presence of a threat of hysteresis, we believe that this concern is already reflected in the current policy stance. As a result, we do not believe that recent comments by the Chairman and the Vice Chair on the possibility of hysteresis in the U.S. raise the probability of further easing, especially QE3.

This is based on a commentary that was published on May 31, 2012.

Contact Macroeconomic Advisers
Tweet Follow @macroadvisers