ESSAYS ON ISSUES

THE FEDERAL RESERVE BANK

OF CHICAGO

2015
NUMBER 338

Chicago Fed Letter

Changing labor force composition and the natural rate
of unemployment
by Daniel Aaronson, vice president and director of microeconomic research, Luojia Hu, senior economist and research advisor,
Arian Seifoddini, senior associate economist, and Daniel G. Sullivan, director of research and executive vice president

This article discusses why changes in the composition of the labor force may have lowered
the natural (or trend) rate of unemploymentthe unemployment rate that would prevail in an
economy making full use of its productive resourcesto 5% or less. A lower natural rate may
help explain why wage inflation and price inflation remain low despite actual unemployment
recently reaching 5.5%a figure only slightly above prominent estimates of the natural rate,
such as that of the Congressional Budget Office (CBO). Demographic and other changes
should continue to lower the natural rate for at least the remainder of the decade.

Over the past 15 years, labor force par-

ticipation (LFP) has steadily declined.

While some of this decline is likely
due to the weak economy, the bulk of
it reflects demographics and other
1. Actual and natural rates of unemployment
long-running trends.1
percent
It is perhaps less well
12
appreciated that the
magnitude (and even
the sign) of the change
10
in the trend LFP rate2
differs significantly
across demographic
8
groups. These divergent trend rates have
6
changed the composition of the labor
4
force in a manner
1982
88
94
2000
06
12
18
that should lower
the natural rate of
Actual unemployment rate
CBO short-run natural rate
unemployment. For
Baseline natural rate
example, the trend
Note: See the text for further details on the two natural rates.
LFP rate has fallen
Sources: Authors calculations based on data from the U.S. Bureau of Labor
Statistics, Current Population Survey; and the Congressional Budget Office (CBO)
especially rapidly for
from Haver Analytics.
teensa group that
always has very high
rates of unemployment. Likewise, the
share of workers without any college

educationanother group with higherthan-average unemploymenthas also

fallen significantly over time.
When we account in some simple ways
for these demographic and educational
changes, we find support for a natural
rate at or just slightly below 5% at the
end of 2014. Moreover, we estimate that
absent major new developments, these
forces will further lower the natural
rate to around 4.4% to 4.8% by 2020.
The effect of demographic and
educational changes

As is well known, the population is

aging.3 The youngest baby boomers
turned 50 in 2014, and roughly half of
them are now in their sixties. Because
this cohort is so large and because the
LFP of older Americans has been rising,
the share of the labor force aged 55 and
older has grown markedlyfrom
around 12.5% in the late 1990s to just
over 22% in 2014. By contrast, because
of both demographics and an especially
pronounced decline in LFP, the share
of the labor force under 25 has been
shrinking. For example, teens made
up almost 8% of the labor force in the

2. Alternative estimates of the natural rate of unemployment

2014:Q4 2017:Q4 2020:Q4

group-specific trend
LFP rates.

Specifically, our trend

unemployment rate
5.4
5.3
5.2
holds the trend unTrend unemployment rate implied by
employment rate for
Age, sex, and education change
every age-sex-education
(baseline)
4.9
4.7
4.5
group fixed at its level
Age and sex change
5.0
4.9
4.8
in the second half of
Age, sex, education, and immigration
change
5.0
4.8
4.6
2005, but allows
groups shares to
Age, sex, and education change and
CBO natural rate equal to actual rate
vary over time as pre in 2001
4.8
4.6
4.4
dicted by our model
Age, sex, and education change with
of LFP. The second
level estimated using inflation data
4.3
4.1
3.9
half of 2005 is chosen
Notes: All values are in percent. See the text for further details.
as a base because it is
Sources: Authors calculations based on data from the U.S. Bureau of Labor Statistics,
the last time the actuCurrent Population Survey; and the Congressional Budget Office (CBO) from Haver Analytics.
al unemployment
rate was equal to the
CBOs estimate of the natural rate. That
early 1980s, but under half that share
is, if one thinks the CBO had the estiin 2014.4
mate right in 2005, our calculations say
Why does this matter for the natural
what compositional change should mean
rate of unemployment? Quite simply,
for trend unemployment over time.
because unemployment rates decline
5
Research has suggested several factors
with age. Since 1982, the teen unemthat may have temporarily increased
ployment rate has averaged over 18%.
By contrast, the unemployment rate for trend unemployment since the start of
the Great Recession in December 2007,
those aged 55 and older has averaged
including 1) mismatch between employroughly 4%. Consequently, the labor
force is increasingly composed of groups ers and workers locations, 2) unusual
difficulty of the long-term unemployed
with low unemployment (e.g., 55 and
in finding jobs (perhaps because of stigolder) and decreasingly composed of
ma or lost human capital), and 3) public
groups with high unemployment (e.g.,
policies such as unemployment insurteens), which suggests a declining
ance extensions.8 Rather than estimate
natural rate.
the impact of these factors ourselves,
Educational attainment has increased
we rely on the CBO. According to the
steadily since the early 1980s.6 Over
CBOs estimates, the short-run natural
that time, the share of the labor force
rate rose sharply from 5.0% in late 2007
25 and older with at most a high school
to 6.0% in 2012, but has now fallen to
diploma has fallen by roughly 20 per5.4% as labor markets have normalized.
centage points, while the share with at
We adjust our trend unemployment
least a college degree has risen by 14 perrate implied by age, sex, and education
centage points. Unemployment rates
to account for the CBOs estimate of
are much lower for those with college
changes to the natural rate since the
degrees,7 so this trend also suggests a
end of 2007.9 This is our baseline.
declining natural rate.
Figure 1 (on the front) plots the actual
To assess the likely magnitude of these
unemployment rate (black line), along
compositional effects on the natural
with our baseline natural rate (red line)
rate of unemployment, we calculate a
and the CBOs estimate of the short-run
trend unemployment rate implied by
natural rate (blue line). From 1982
changes in the age, sex, and educationthrough 2007, the total decline in our
al composition of the labor force using
baseline natural rate is quite similar to
19822014 data from the U.S. Bureau
that of the CBOs natural rate, though
of Labor Statistics Current Population
their paths are somewhat different.
Survey (CPS) and our estimates of
CBO short-run natural rate as
of January 2015

The CBOs natural rate declined from

6.1% in 1982 to 5.0% by 2000 and then
remained flat through 2007, whereas
our baseline trend rate declined steadily
from about 6.2% in the early 1980s to
4.8% in 2007.
We find that our age-sex-education adjustment (excluding the post-2007 CBO
adjustment) causes the natural rate to
decline by 0.37 percentage points in
200714 and by 0.63 percentage points in
200014, or, on average, about 0.04 percentage points per year over the past
15 years. In other words, the natural
rate of unemployment would have been
0.37 percentage points lower in 2014:Q4
if the age, sex, and education composition of the trend LFP rate had remained
the same as in 2007 and 0.63 percentage
points lower if this composition had
remained the same as in 2000.
We estimate our baseline natural rate
of unemployment as of 2014:Q4 to be
4.9% (figure 2, second row)0.5 percentage points lower than the CBOs
estimate of the short-run natural rate
(figure 2, first row). We project this
rate to fall by about 0.06 percentage
points per year through the end of the
decade, reaching 4.5% at the end of
20200.7 percentage points below the
CBOs estimate.10
Two broad assumptions underlie these
simple calculations. First, demographics
and educational attainment are fundamental determinants of unemployment,
and thus, changes in them over time
should drive overall levels of aggregate
unemployment. Second, the unemployment rate was at its natural rate in late
2005. Both of these assumptions seem
plausible, but neither is completely unassailable. Accordingly, in the next two
sections, we explore the sensitivity of
our results to alternative assumptions.
Sensitivity to different adjustment
variables

First, we consider how our estimates

change when we adjust the natural rate
with alternative sets of variables.
While there is a strong inverse relationship between educational attainment and
unemployment, Summers has argued
against using educationally adjusted

natural rate series because they imply

counterfactually high unemployment
in earlier decades when educational
attainment was much lower.11 Similarly,
Shimer has argued that observed crosssectional differences in unemployment
by educational attainment could simply
reflect more-able people having chosen
to get more education (i.e., a selection
effect), instead of a causal effect from
getting more schooling.12 Our reading
of the available evidence on educations
effect on wages runs counter to this
argument.13 Still, the fact that unemployment rates were not high in the
1950s suggests that it is worth redoing
our calculations using groups defined
by only age and sex.
The results of this calculation are shown
in the third row of figure 2. Evidently,
when we adjust for only age and sex,
the direction of the results is the same,
but the magnitude of the change is somewhat smaller. Including the post-2007
CBO adjustment, our age-sex-adjusted
natural rate as of the end of 2014 was
5.0%a tenth higher than the rate with
an education adjustment. We project
this rate to fall by about 0.05 percentage
points per year through the remainder
of the decade, so that it stands at 4.8%
by the end of 2020. From the differences
in these two hypothetical rates paths,
we infer that about three-quarters of
the drop during the remainder of the
decade will arise from changes in the
age structure and the remainder from
growth in educational attainment.
We also considered making an additional
adjustment for changes in immigration
(figure 2, fourth row). The expected
direction of this additional adjustment
is unclear, depending as it does on
whether immigrants have lower unemployment than natives, conditional on
age, sex, and education. However, we
find that at the end of 2014, the age-sexeducation-immigration-adjusted natural
rate was 5.0%0.1 percentage points
higher than the version that does not
adjust for immigration.14
Sensitivity to the natural rates
starting level

The estimates reported thus far rely on

the assumption that the unemployment

rate was at its long-run trend during the

second half of 2005. As we noted, that
seems plausible and accords with the
CBO assessment, but other possibilities
are worth considering.
One obvious alternative is that the actual unemployment rate was equal to
the natural rate the previous time the
CBO thought this was the caseduring
the second half of 2001.15 The fifth row
of figure 2 shows that if unemployment
was at its natural rate in 2001, our current estimate of the trend rate would
be a tenth of a percentage point lower
than our baseline path (second row).
A more theoretically appealing way to
establish the overall level of the natural
rate is with inflation data. Therefore,
as an additional check on our results,
we estimate a Phillips curve model that
relates an inflation gap to its own lagged
values, the unemployment rate gap, and
short-term supply shock terms (relative
import prices and energy prices). A
combination of the coefficients from
this model provides an estimate of how
much our baseline path for the trend
rate should be adjusted up or down to
best fit the historical relationship between these variables.16 Our inflation
gap measure is the deviation of annualized quarterly core inflation17 as measured by the Price Index for Personal
Consumption Expenditures (PCE)
from long-term inflation expectations.18
The model is estimated on data from
1982 through 2007, the period for
which we can compute our natural rate
series without adjusting for the effects
of the Great Recession.
The results, shown in the sixth row of
figure 2, suggest that the natural rate
could be about a half of a percentage
point lower than our baseline. It should
be noted, however, that while using inflation data is appealing theoretically, in
practice, the magnitude of the implied
adjustment is imprecisely estimated,
with a standard error of approximately
0.5 percentage points. This imprecision
reflects the fairly weak relationship between inflation and unemployment gaps
that is often reported in the literature.19
That said, various reasonable tweaks to
our specification, such as using wage

rather than price inflation data, also

suggest downward adjustments to the
level of the natural rate. Therefore, we
consider our preferred age-sex-educationadjusted estimates in the second row to
be, if anything, a touch conservative.
Conclusion

While great progress has been made

over the past few years, significant labor
market slack remains. We estimate the
natural rate at or below 5%, at least half
of a percentage point below its actual
level as of March 2015. This estimate of
slack, in combination with labor market
measures such as LFP and involuntary
part-time workers (see note 1), may
help explain why wage inflation and
price inflation remain so low. Moreover,
we estimate that absent major new developments, demographic and educational
changes will persist, potentially reducing
the trend unemployment rate to around
4.4% to 4.8% by 2020.
See https://www.chicagofed.org/
publications/economic-perspectives/
2014/4q-aaronson-etal.

The trend LFP rate is the LFP rate consistent with the contemporaneous composition of the work force and an economy
growing at its potential.

Charles L. Evans, President; Daniel G. Sullivan,

Executive Vice President and Director of Research;
Spencer Krane, Senior Vice President and Economic
Advisor; David Marshall, Senior Vice President, financial
markets group; Daniel Aaronson, Vice President,
microeconomic policy research; Jonas D. M. Fisher,
Vice President, macroeconomic policy research; Richard
Heckinger,Vice President, markets team; Anna L.
Paulson, Vice President, finance team; William A. Testa,
Vice President, regional programs, and Economics Editor;
Helen OD. Koshy and Han Y. Choi, Editors;
Julia Baker, Production Editor; Sheila A. Mangler,
Editorial Assistant.
Chicago Fed Letter is published by the Economic
Research Department of the Federal Reserve Bank
of Chicago. The views expressed are the authors
and do not necessarily reflect the views of the
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Reserve System.
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ISSN 0895-0164

 See, e.g., http://www.census.gov/

prod/2014pubs/p25-1140.pdf.

See figure A1 in web appendix, available

at https://www.chicagofed.org/~/media/
others/people/research-resources/
aaronson-daniel/aaronson-etal-cfl-338appendix-pdf.pdf.

See figure A2 in web appendix (see note 4).

See figure A3 in web appendix (see note 4).

See figure A4 in web appendix (see note 4).

For example, over the past 30 years, the
average unemployment rate for college
graduates was 10 percentage points lower
than for high school dropouts.

See, for example, the CBOs discussion of

the natural rate of unemployment:
https://www.cbo.gov/sites/default/files/
cbofiles/attachments/49892Outlook2015.pdf.

Specifically, we adjusted our hypothetical

hypo
CBO _ SR
5.0) for
natural rate by ut + (ut
all years after 2007, where utCBO _ SR is the
CBOs short-term natural rate; utCBO _ SR was
constant at 5.0% in 200007.

Our previous work (see note 1) provides

estimates of the natural rate that differ
somewhat from those reported here. The
main difference is that we now incorporate
the CBOs latest estimate of its short-run
natural rate, released in January 2015.

10

Lawrence H. Summers, 1986, Why is the

unemployment rate so very high near full
employment?, Brookings Papers on Economic
Activity, Vol. 17, No. 2, pp. 339383.

11

Robert Shimer, 1999, Why is the U.S. unemployment rate so much lower?, in NBER
Macroeconomics Annual 1998, Ben S. Bernanke
and Julio J. Rotemberg (eds.), Vol. 13,
Cambridge, MA: MIT Press, pp. 1161.

unemployment rate gap, xt is the short-term

supply shock variables, and et is an error term.
(The parameters and are the regression
coefficients on the (u u*) and x variables,
respectively.) The equation can be rewritten
as t = + (ut t)+ xt + et. (The parameter is the constant term.) Consequently,
u0 can be recovered from the ratio of the
coefficients / estimated from a regression of t on a constant, ut t , and xt. Our
inflation gap measure is defined as the deviation of actual inflation from its expectation in the prior period, which in turn is
defined as a weighted average of past inflation and long-term inflation expectations.
The adjustment factor / reported in
figure A5 of the web appendix (see note
4) is added to our baseline path (figure 2,
second row) to get the path reported in
the sixth row of figure 2.

12

See, e.g., David Card, 1999, The causal

effect of education on earnings, in
Handbook of Labor Economics, Orley C.
Ashenfelter and David Card (eds.), Vol. 3A,
Amsterdam: Elsevier / North-Holland,
pp. 18011863.

13

Our calculation of a 0.1 percentage points

immigration adjustment is based on a comparison of an immigration-adjusted versus
a non-immigration-adjusted natural rate
from 1994 through 2014, the period during
which the CPS reports immigration status.

14

Unlike in the second half of 2005, the unemployment rate in the second half of 2001
was not exactly equal to the CBOs estimate
of the natural rate. Accordingly, to establish
a base for the natural rate series, we adjusted
all age-sex-education unemployment rates
in 2001:Q3 and 2001:Q4 proportionately
to make the overall rate equal to the CBOs
natural rate. These adjusted rates form
the base for the natural rate calculation
reported in the fifth row of figure 2.

15

In particular, call the estimates of the

natural rate in figures 1 and 2 and
assume the true natural rate ut* = t + u 0 .
We try to pin down u0 using a Phillips
curve regression of the following form:
t = (ut ut* ) + x t + e t , where t is the
measure of the inflation gap, ut is the
actual unemployment rate, ut ut* is the

16

Core inflation strips out the volatile food

and energy prices.

17

These expectations are from the Philadelphia

Feds Survey of Professional Forecasters ten-year
Consumer Price Index (CPI) inflation rate,
spliced with the Hoey Surveys CPI inflation
forecasts for the years before 1991, and
then adjusted for the long-run gap between
CPI and PCE inflation.

18

See, e.g., Douglas Staiger, James H. Stock,

and Mark W. Watson, 1997, How precise are
estimates of the natural rate of unemployment?, in Reducing Inflation: Motivation and
Strategy, Christina D. Romer and David H.
Romer (eds.), Chicago: University of
Chicago Press, pp. 195246.

19