Estimating the NAIRU and the Natural Rate of Unemployment for New Zealand

Indicators of labour market slack such as the unemployment rate provide an important input into the Reserve Bank’s assessment of capacity pressures in the economy, and therefore wage and price inflation. A measure of capacity pressure in the labour market is the unemployment gap, the difference between the headline rate of unemployment and some ‘equilibrium’ level of unemployment. Economists typically refer to this underlying level as the natural rate of unemployment or the Non-Accelerating Inflation Rate of Unemployment (NAIRU), and the two terms are sometimes used inter-changeably. In this Analytical Note, we distinguish between these two unobservable measures of equilibrium unemployment. Then, using estimated macroeconomic relationships, we filter the data to obtain measures of the NAIRU and the natural rate for New Zealand. While the natural rate of unemployment and the NAIRU are synonymous in the long run, there is an important distinction between the two concepts over shorter horizons. The natural rate is essentially a steady-state concept – it is the level of unemployment that reflects the structure of the labour market (for example, its demographic make-up, institutional and contractual factors, and technology), and after transitory shocks have fully worked through labour and product markets. The NAIRU concept is similar to the extent that it is affected by similar structural forces in the economy. However it is not a steady-state concept – instead it represents the level of unemployment consistent with stable inflation in the short to medium term. The NAIRU takes into account the influence of structural changes and other shocks in the economy, and how they interact with frictions in labour and product markets. In the long run, the NAIRU converges to the natural rate of unemployment once the effects of the shocks hitting the economy have faded. Much of this Analytical Note focuses on the NAIRU, which is the more relevant concept for understanding inflationary pressure over the medium-term time horizon relevant for monetary policy. The focus of monetary policy is to minimise fluctuations in cyclical unemployment, as indicated by the gap between the unemployment rate and the NAIRU, while also maintaining its objective of price stability. Monetary policy has limited influence on the natural rate of unemployment. However, since the natural rate can be influenced via structural policies, it is the more relevant measure of equilibrium unemployment for the long-term objectives of the Government. For 2017Q3, the end-point of our sample, our NAIRU estimates correspond to an unemployment gap that is around zero. This is consistent with other measures of capacity pressures. However, we emphasise that point estimates of the NAIRU and the natural rate are imprecise and highly sensitive to sample periods, data choices, and model specifications. The confidence interval of our estimates approximately spans from 4.0 to 5.5 percent. This imprecision suggests that other observable indicators are needed to supplement estimates of equilibrium unemployment in assessing the overall degree of labour market slack.