Challenges to the Natural Rate

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The central premise of the natural-rate hypothesis is that the natural rate itself is independent of inflation. It may shift due to microeconomic factors such as changes in the skill-composition of the job pool and the labor force, changes in policies such as minimum wages or unemployment insurance, or changes in the strength and behaviour of labor unions, but changes in inflation are assumed to have no effect on the natural rate. However, two theories have recently suggested ways that inflation could affect the natural rate of unemployment.

The first is the hypothesis of hysteresis in unemployment. According to the hysteresis theory, periods of high unemployment, such as would result from prolonged disinflations, would cause the natural rate itself to increase. Among the reasons why this might occur are deterioration of relevant job skills by the long-term unemployed and disenfranchisement of unemployed “outsiders” in the process of negotiating wages and employment levels.

Hysteresis is a possible explanation for the experience of continental Europe since 1980, where unemployment has been well above historical levels for two decades.

While inflation has been quite low, it seems implausible that core inflation would not have adjusted to the lower inflation rate by now. Thus, it is unlikely that unemployment has been above the natural rate all this time. Instead, it seems probable that the natural rate itself is higher. The hysteresis theory proposes that high unemployment itself caused the natural rate to rise.

A more recent challenge to the natural-rate hypothesis proposes that there may be a leftward bulge at low inflation rates in the otherwise vertical long-run Phillips curve. The rationale behind the bulge theory is that when inflation is low, people may ignore it altogether and behave as though core or expected inflation is zero.21 If inflationary expectations do not adjust to permanent changes in inflation that stay near zero, then the downward-sloping original Phillips may be valid in that range.

Inflation of, say, 2 percent might lead to permanently lower unemployment than zero inflation if people ignore the inflation. This theory could explain how the United States has been able to achieve and sustain remarkably low unemployment rates in the late 1990s with steady but low inflation.