The Ins and Outs of Unemployment in the Long Run: Unemployment Flows and the Natural Rate

Working papers of the Federal Reserve Bank of Cleveland are preliminary materials circulated to stimulate discussion and critical comment on research in progress. They may not have been subject to the formal editorial review accorded offi cial Federal Reserve Bank of Cleveland publications. The views stated herein are those of the authors and are not necessarily those of the Federal Reserve Bank of Cleveland or of the Board of Governors of the Federal Reserve System. This paper proposes an empirical method for estimating a long-run trend for the unemployment rate that is grounded in the modern theory of unemployment. I write down an unobserved-components model and identify the cyclical and trend components of the underlying unemployment fl ows, which in turn imply a time-varying estimate of the unemployment trend, the natural rate. I identify a sharp decline in the outfl ow rate—the job fi nding rate—since 2000, which was partly offset by the secular decline in the infl ow rate—the separation rate—since the 1980s, implying a relatively stable natural rate, currently at 6 percent. Numerical examples show that slower labor reallocation, along with the weak output growth, explains most of the persistence in unemployment since the Great Recession. Contrary to the business-cycle movements of the unemployment rate, a sig-nifi cant fraction of the low-frequency variation can be accounted for by changes in the trend of the infl ows, especially prior to 1985. Finally, I highlight several desirable features of this natural rate concept that makes it a better measure than traditional counterparts. These include statistical precision, the signifi cance of required revisions to past estimates with subsequent data additions, policy relevance and its tight link with the theory.