- The Washington Times - Sunday, June 12, 2005

From Wall Street to the Federal Reserve, from universities to think tanks, economists are constantly building models to help fill in the blank spots in our economic statistics.

They sometimes use models to manufacture their own data. One way is by estimating equations or developing techniques using existing data, from which they derive data that are not or cannot be directly collected. One reason the data may not be collectable is their hypothetical nature.

For example, economic policymakers want to know the economy’s noninflationary potential rate of growth in order to determine how far from its potential the economy is at any given time. Since potential growth is not directly observable, economists build models to estimate the potential growth path. Currently, that path is estimated at about 3 percent annually.

A major component of potential output is the potential or full-employment labor force. Estimating the size of the labor force under constant noninflationary full-employment conditions enables economists to measure the labor force gap. This is the difference between the actual and potential labor force, representing the degree of labor’s underuse or unemployment.

Labor force gap estimates sometimes, as happened recently, tell a different story than government labor force numbers.

Over the last three months, unemployment as officially measured has been virtually flat. Last month, though the unemployment rate rounded down from 5.2 percent in April to 5.1 percent in May, the reported number of unemployed fell only 16,000. As in April, the Labor Department announced May unemployment “was essentially unchanged.”

The labor force gap, however, declined sharply in April, by nearly a half-million, and declined further in May by more than 200,000. This drawing down of unused labor resources was reflected in a rising labor force participation rate in the last two months as it moved toward its potential growth path. Though the job market tightened, model-generated estimates of potential labor supply tell us considerable unused labor capacity remains, much of it invisible to the official unemployment data.

The indication of an improved job market last month as reflected in a reduced labor force gap not only contradicts the official data showing flat unemployment, but also conflicts with the sluggish 78,000 rise in business payroll jobs. Such a job increase is too small to keep up with population growth or significantly reduce unemployment.

On the other hand, the positive message of a shrinking labor supply gap is supported by, and in part derives from, the 376,000 May jump in total employment as measured by the government’s household survey. Though household-measured employment can be volatile from month to month, the Labor Department most recently noted that total employment and the employment-population ratio “continued to trend up.”

The modest gain in payroll jobs last month sparked talk that the Federal Reserve’s Open Market Committee (FOMC) might notch up the federal funds target rate by a quarter-point only once or twice more in upcoming meetings. The federal funds rate now stands at 3 percent. However, estimates of a declining labor force gap coupled with new data on employer labor costs change the odds that the FOMC will continue raising short-term rates beyond its next two meetings. Both labor force and labor cost data have direct implications for inflation and are closely watched by the Fed.

The Labor Department recently published revisions to its labor cost data for the nonfarm business sector that show a more worrisome picture than prior estimates.

Labor costs per unit of output have been on a rising trend since last year’s second quarter. The latest revisions raised the quarter-to-quarter increase for the first quarter of this year from 2.2 percent to 3.3 percent annualized. Year-over-year, the first-quarter rise was revised to 4.3 percent from 2 percent initially. The third- to fourth-quarter rise in 2004 was also revised upward from 1.7 percent to a startling 7.7 percent increase. For the past three quarters together, the revisions show a more than 5 percent average quarter-to-quarter increase in unit labor costs, double the previous estimate.

With business pricing power strengthening, as the Fed has noted, labor cost increases of this magnitude will likely be passed on to consumers, thereby adding to inflationary pressures. If we also take into account an improving labor market, persistently high energy costs that many economists expect soon to spill over into core inflation, and an economy expected to grow at an above-potential 3 percent rate this year, it could be a bad gamble to bet on the Fed’s ending its gradual tightening before the end of the year.

Alfred Tella is former Georgetown University research professor of economics.

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