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Is the US economy running out of doldrums? by Willem H. Buiter

Given the unprecedented nature of the COVID-19 pandemic and its impact on labor markets, there is a lively debate over whether the U.S. economy is on the verge of regaining its full potential. If so, there is a risk that the US Federal Reserve will fall behind the curve.

NEW YORK – How much slack is there in the US economy? In economics, the “gap version” of Okun’s law says that a rise in the unemployment rate of one percentage point is accompanied by a decline in the real (inflation-adjusted) GDP growth rate by two percentage points below its potential. The gap is important because the closer the economy is to its potential, the more we should be concerned about inflation.

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According to the Bureau of Labor Statistics (BLS), the US unemployment rate was 5.9% in June, up from 3.5% before the pandemic (February 2020). If one takes the latter value as an estimate of the natural unemployment rate, the result is an output gap of 4.8%. Assuming potential output growth at an annual rate of 2%, non-inflationary real GDP growth would reach 6.8% for the coming year. With the US Federal Reserve expecting 7% growth this year and 3.3% growth in 2022, that would suggest that the US is at least a few years away from inflation.

This estimate of the output gap can be criticized as either too low or too high. The under-stock argues that official unemployment figures – 9.5 million in June 2021 versus 5.7 million in February 2020 – underestimate the shortage in the labor market. The BLS reports that in June, “the number of inactive people currently looking for work was 6.4 million”, up from “1.4 million since February 2020”. After taking into account this additional 1.4 million, the unemployment rate rises to 6.8%, which corresponds to an output gap of 6.6%.

In addition, the number of people working part-time for economic reasons has increased by 229,000 since February 2020. Treating this category as unemployed would raise the unemployment rate to 6.9% and the output gap to 6.8%. The BLS also publishes an estimate of temporarily laid off workers who should have been classified as unemployed but were mistakenly classified as employed. If you count these, the seasonally adjusted unemployment rate would rise to 7.1% in June 2021, representing a 7.2% output gap.

But those in the high camp insist that there is little or no weakness in the economy. You would object to all three of the above changes in the unemployment rate. Why should someone who is not looking for a job or not available be counted in the labor force? Part-time workers are counted as part-time unemployed. And even the BLS admits that its estimate of “employed” temporarily laid off workers is likely to overestimate the extent of the misclassification error.

Additionally, they would claim that the natural rate is likely to be above 3.5%. The key number to be considered is vacant positions. In May 2021 there were 9.2 million (5.7 percent of the labor force) “total jobs outside agriculture”, which was almost the official number of unemployed (9.3 million). There are also consistent reports from across the country of companies struggling to find workers, suggesting that there is a massive mismatch between labor demand and supply. If the actual labor supply is significantly lower than the fictitious supply, the natural unemployment rate inevitably rises.

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Given the impact of the COVID-19 pandemic, such a massive labor imbalance is certainly plausible. The nature of the job has changed dramatically with lockdowns and other non-pharmaceutical interventions. In some cases, working from home is nowhere near as productive as working in an office, factory, or other non-residential workplace.

Despite the lifting of most government restrictions on employment-related activities, concerns about COVID-19 contagion have limited the full return to pre-pandemic work arrangements. Finally, childcare obligations continue to keep many workers (especially women) at home. In view of the limited care capacities, the parental labor supply is inevitably impaired.

Provided the pandemic doesn’t get out of hand again, the fall of the school year should see a steady return to normality before the crisis. But even then, some things will have changed permanently, which means that at least some of the labor imbalances may turn out to be structural in nature. In particular, the rapid introduction of digital technologies – including a veritable information and fintech explosion – is already part of the new normal.

These new skills will make many jobs in both manufacturing and service sectors obsolete. In fact, there are good reasons to believe that an automation field day is already underway. While the technological revolution sparked by the pandemic will undoubtedly create new jobs, it has inevitably led to labor-saving and job-replacing innovations.

With the pandemic push towards automation being unprecedented, there is no reliable numerical estimate of its impact on labor markets. My best guess is that it could easily increase the natural unemployment rate by a percentage point or two, with an associated decrease in the output gap of 2-4 points.

Finally, it should be examined whether financial incentives have reduced the effective labor supply. In addition to the extended unemployment benefit, which expires in September 2021, there were also various cash payments, including additional child benefit. This eases budget constraints for many workers, allowing them to be more picky about employment. But this also means that there could be a positive labor supply shock in September. Although there are no reliable estimates of a “labor pension effect”, I assume that the natural unemployment rate will decrease by 0.5 point, which increases the output gap by one point.

Without the three “greater headroom” amendments mentioned above, my preliminary estimate of the output gap after September 2021 is between 1.8% and 3.8%, which leaves room for non-inflationary growth of 3.8% to 5.8% for the coming year implies. But that margin could be exhausted within a year, putting the Federal Reserve in danger of falling behind.

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