Goldman's Hatzius: "The Employment Gap Is Much Bigger than the FOMC's Current Estimate"

Some excerpts from a research piece by Goldman Sachs chief economist Jan Hatzius: The Employment Gap Is Much Bigger than the FOMC's Current Estimate of the Unemployment Gap

The Fed's most "official" view of excess labor market slack is the gap between the unemployment rate (currently 5.4%) and the midpoint of the FOMC's central tendency range for the "longer-term" rate (currently 5.1%), which is usually taken to be an estimate of the structural unemployment rate. Taken at face value, this implies that the US economy can only create an additional 500,000 jobs before the labor market starts to overheat. ... If this is the right perspective, it would be entirely sensible, and perhaps urgent, to start normalizing monetary policy soon.

But we think it is a misleading perspective, for two reasons. First, the FOMC's current estimate of the structural unemployment rate is likely to continue falling ... This would not only be in keeping with the trend over the past two years, but also with a new study by the Chicago Fed which argues that population aging is likely to push structural unemployment significantly lower over time. ... If the Chicago Fed estimates are correct, the economy would be able to create about 800,000 jobs before the labor market starts to overheat in the short term, and as many as 1.4 million jobs in the longer term. This would already imply significantly less urgency to start normalizing monetary policy than the 500,000 jobs gap implied by the current FOMC estimate of the structural unemployment rate.

Second, there is probably significant labor market slack outside the unemployment gap because there is an important cyclical element in the decline of the labor force participation rate since 2007. This is consistent with Federal Reserve Research. For example, we can use updated estimates of the "demographically adjusted" employment/population ratio by Samuel Kapon and Joseph Tracy at the New York Fed to calculate another, broader version of the current jobs gap. Under the assumption that the labor market was at full employment in the third quarter of 2005--in line with the CBO estimate used in the Chicago Fed estimate above--the Kapon-Tracy numbers imply that the employment/population ratio is currently 1.2 percentage points below its equilibrium level. Multiplying this number by the over-16 population of about 250 million, the implied jobs gap is as large as 3 million. This implies much less urgency to start normalizing monetary policy than the unemployment-based numbers discussed above, and it is an important reason why we think it would be better for the FOMC to wait until 2016 before starting the normalization process.

CR Note: Here is the Chicago Fed Research Hatzius references: Changing labor force composition and the natural rate of unemployment. It is difficult to estimate the amount of slack in the labor market. However, because the risks are not symmetrical (normalizing monetary policy too soon is more risky than normalizing too late), this is an argument for waiting until there are signs of a pickup in wages and inflation.   However, as Yellen recently noted: "we need to keep in mind the well-established fact that the full effects of monetary policy are felt only after long lags. This means that policymakers cannot wait until they have achieved their objectives to begin adjusting policy."