*By Zach Pandl, Portfolio Manager and Strategist *

A consensus among Fed officials holds that the standard U3 unemployment rate-now at 6.2%-"considerably" understates slack in the labor market. As a result, policy should focus on broader measures like the U6 unemployment rate-which includes discouraged workers and part-time workers who would prefer full-time work-or statistical estimates of the total "employment gap" (such as that from economist Andrew Levin; see here). This idea has now made it into the official FOMC statement, which said in July, "a range of labor market indicators suggests that there remains significant underutilization of labor resources."

Leaving aside the merits of this argument (see here for our views), one important question remains unresolved: how exactly will policymakers adjust the funds rate and balance sheet in light of this additional labor market slack? Fed officials have stressed the underemployment problem, but have offered few details about how it affects the policy outlook-instead, they've tied the exit discussion to the notion of "headwinds" (background here). This year's Jackson Hole Conference would be a good moment for Fed Chair Yellen to clarify her views on underemployment and its policy implications.

The commonplace answer to this question is that one should simply adjust the slack term in the Taylor Rule (or other policy rule) to account for underemployment. For instance, a typical version of the Taylor Rule can be written as:

where r is the funds rate, r* is the neutral (nominal) funds rate, U3 and U3* are the standard unemployment rate and its natural rate, π and π*are the inflation rate and the Fed's inflation target, and the two γ (gamma) terms reflect the responsiveness of policy to unemployment and inflation gaps.

In order to account for labor market slack beyond the standard unemployment rate, one could adjust the unemployment rate measure to capture "true" labor market slack. Based on pre-crisis relationships, the popular U6 measure implies a "true" unemployment rate of 7.1% today-significantly higher than the 6.2% reported U3 rate (Exhibit 1). This implies an unemployment gap that's 0.9 percentage points (pp) wider, and a warranted funds rate from the Taylor Rule that's 1.8pp lower (using a slack coefficient of 2.0, as Fed Chair Yellen has in past speeches). This is a big difference in the warranted funds rate, and goes a long way to explaining why policy has deviated from standard rules.

Exhibit 1: U6 could imply "true" unemployment rate of 7.1%

However, it's not generally appropriate to apply the Taylor Rule in this way. The parameters of the Taylor Rule are not laws of the universe. Rather, they're what economists call "reduced form" estimates: historical averages, not structural features of the US economy. The responsiveness of policy to unemployment and inflation gaps-the gamma terms in the Taylor Rule-will differ based on (1) policymaker preferences and (2) the underlying structure of the economy. Thus, if we use a different slack term in the Taylor Rule, we probably need to change the other terms in the equation too.

In fact, under certain assumptions it's possible to express the Taylor Rule's response parameters in terms of the underlying structure of the economy (see, for example, Laurence Ball, "Efficient Rules for Monetary Policy." NBER Working Paper, March 1997). Specifically, these variables can be written as:

where β is the sensitivity of economic slack to interest rates (the slope of the I/S Curve), λ is the persistence of slack, α is the sensitivity of inflation to slack (the slope of the Phillips Curve), and q is a measure related to policymaker preferences (see reference for details). If, for example, the sensitivity of inflation to slack were to change, the terms in the Taylor Rule would change too.

We see two reasons why these policy response parameters in the Taylor Rule might be smaller if Fed officials were focused on a broad measure of labor market slack. First, discouraged workers and the underemployed may have a smaller impact on inflation than unemployed persons actively searching for work (i.e., the slope of the Phillips Curve is flatter for broader measures of labor market slack). Unfortunately, because the various measures of labor market slack have been highly correlated until recently, it's challenging to sort out these differences with statistical analysis. This is true even when using state level data (as discussed here). We suspect Fed officials are making an assumption that the impact of the underemployed on wage and price inflation is somewhat lower than for the unemployed (similar to the assumption in Erceg and Levin 2013), but this would be a helpful point to clarify.

Second, welfare implications for the underemployed might be different than for the unemployed. This question is really a judgment call for policymakers, but we would presume that the negative financial and psychological effects of economic weakness are less severe for workers with part-time employment than for active jobseekers. If that's the case, the sensitivity of the funds rate to slack would be smaller when targeting broad measures of labor market slack.

We think Janet Yellen's July Humphrey-Hawkins testimony offered a hint about how Fed officials might be incorporating the underemployment issue into policy discussions in practice. In response to a question about the size of the output gap, Yellen offered the following:

"The unemployment rate is 6.1 percent; members of our participants in the FOMC would see a normal longer-term unemployment rate in the range of 5.2 (percent) to 5.5 percent. So you know, taking the lower end of that range is, say, a 0.9 percent gap in terms of the unemployment rate. A simple historical relationship that's fit pretty well-this is just back-of-the-envelope; it's not precise-called "Okun's law" would say that … the output gap tends to be on the order of 2 (times) or 2.5 times that in terms of a percentage of GDP. So I think that gets us in the range of something like 2 (percent) or a little bit over 2 percent in terms of an output gap."

Using the midpoint of the longer-term unemployment rate estimates (5.35%, the average of 5.2% and 5.5%) implies an unemployment gap at this time of 0.75pp. In addition, Okun's Law for the US is actually about 1.8, not 2.0-2.5 (Exhibit 2). Thus, at face value these figures imply an output gap of 1.35% (=0.75*1.8). In her calculation, Yellen instead uses the bottom end of the longer-term unemployment rate range and an abnormally large coefficient for Okun's Law, arriving at an output gap of 2% or a bit more. We suspect this is a quick-and-dirty way of accounting for underemployment: by grossing up the working estimate of the output gap with a low NAIRU and large Okun coefficient.

Exhibit 2: U.S. output gap usually 1.8 times unemployment gap

In truth though, Yellen's Humphrey-Hawkins Q&A was far from a fully articulated description about how Fed officials are dealing with these issues. The latest FOMC statement suggests policymakers have pivoted further away from their traditional focus on the U3 unemployment rate. However, there's still considerable uncertainty around what measure of slack they are using and how it fits into the policy planning process. Unfortunately, traditional tools like the Taylor Rule need to be recalibrated if the central bank focuses on a different measure of slack, so they offer little guidance to investors at the moment. We hope this week's Jackson Hole conference will shed some light on these questions.

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