NAIRU

NAIRU — the Non-Accelerating Inflation Rate of Unemployment — is the unemployment rate at which inflation neither accelerates nor decelerates. It is the rate consistent with stable prices. When actual unemployment falls below NAIRU, inflation tends to accelerate; when it rises above, inflation tends to decelerate.

The Phillips curve connection

NAIRU is defined through the Phillips curve relationship:

Inflation = Expected Inflation + α × (Unemployment gap) + Supply shocks

Where the unemployment gap = Actual Unemployment − NAIRU

When actual unemployment equals NAIRU (gap = 0), inflation moves at the rate of expected inflation — it is stable. When unemployment falls below NAIRU, the gap is negative, and inflation accelerates. When unemployment rises above NAIRU, inflation decelerates.

Estimation challenges

NAIRU is unobservable. It must be estimated, and estimates are uncertain:

• Survey-based estimates ask economists to guess; these usually range from 4% to 4.5% in the US.
• Statistical estimates fit the Phillips curve to historical data; these can vary depending on the sample period and methodology.
• Time-varying estimates allow NAIRU to change with demographics and labor institutions; these suggest NAIRU was 5.5–6% in the 1970s-80s, falling to 4–4.5% in the 2000s-10s.

The Federal Reserve publishes its estimate in the “Summary of Economic Projections” each quarter. Current estimates range from 4.0% to 4.5%, though economists debate whether the true NAIRU is lower (3.8%) or higher (4.8%).

Why NAIRU is time-varying

NAIRU shifts with:

• Demographic changes. An aging population might have lower NAIRU because older workers turn over less frequently. More young workers might raise it because youth unemployment is cyclical.
• Labor market institutions. Strong unions and job protection raise NAIRU; flexible labor markets lower it.
• Structural unemployment. Skills mismatches or geographic mismatches can raise NAIRU; better matching technologies can lower it.
• Inflation expectations. If expected inflation is anchored (everyone expects 2% inflation), NAIRU is lower. If expectations are unanchored (everyone expects 5%), NAIRU is higher.

The decline in NAIRU from ~5.5% in the 1980s to ~4% in the 2010s may reflect lower inflation expectations, a shift from manufacturing to services, demographic aging, and labor market deregulation.

The policy challenge

The Federal Reserve sets interest rates partly based on where it thinks NAIRU is:

• If actual unemployment < estimated NAIRU: The Fed will raise rates to cool demand and prevent inflation.
• If actual unemployment > estimated NAIRU: The Fed will cut rates to stimulate demand and reach full employment.

But if the Fed’s NAIRU estimate is wrong, policy goes awry:

• If actual NAIRU > Fed’s estimate: The Fed will raise rates unnecessarily when unemployment is still high, causing a recession.
• If actual NAIRU < Fed’s estimate: The Fed will cut rates when unemployment is already low, allowing inflation to spiral.

The late 2010s provide an example: the Fed kept unemployment above what turned out to be sustainable levels, then belatedly cut rates in 2019. This debate continues: Did the Fed keep NAIRU too high in 2020-21, or did supply shocks drive the 2021-22 inflation?

NAIRU and wage growth

In practice, wage growth is often watched as a proxy for NAIRU proximity. When unemployment is below NAIRU, firms compete for workers, wages accelerate, and workers expect inflation, accelerating prices. When unemployment is above NAIRU, wage growth is weak and inflation decelerates.

The relationship is not mechanical — supply shocks and inflation expectations matter — but it is robust.

Inflation expectations and NAIRU

An important refinement: NAIRU only produces stable inflation if inflation expectations are anchored. If everyone believes inflation will remain 2%, then NAIRU is at the unemployment rate consistent with 2% inflation.

But if inflation expectations drift — workers and firms expect 4% inflation — then NAIRU becomes higher (because the same unemployment rate will produce 4% rather than 2%). The Federal Reserve’s credibility in maintaining low inflation expectations thus affects the level of NAIRU.

See also