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Thursday, September 2, 2010

Unemployment and Economic Recovery

Linda Levine
Specialist in Labor Economics

Although the economy has begun growing again, it may be a while before the unemployment rate shows steady improvement. The unemployment rate is considered a lagging indicator, meaning that its ups and downs happen some time after the ups and downs of other indicators of economic activity. For example, more than a year elapsed before the unemployment rate trended downward following the end of the 1990-1991 and 2001 recessions. This led the two to be labeled jobless recoveries. By contrast, after four earlier recessions the unemployment rate began a sustained decline within four to five months. 

Unemployment often does not fall appreciably when economic growth first picks up because some firms may have underutilized labor that they kept on their payrolls during the recession to avoid incurring costs related to layoffs and rehiring. At the end of a recession as demand increases, some firms may initially be able to increase production without adding workers by raising the productivity of the labor on hand. But once the labor on hand has been fully utilized, output will grow at the growth rate of productivity until firms add workers. As an economic expansion progresses, output growth will be determined by the combined rates of productivity and labor force growth. If output growth exceeds the growth rate of productivity, then employment will rise. If employment growth exceeds the labor force growth rate, then the unemployment rate will fall. 

Just as the time it takes for the unemployment rate to begin falling after a recession has varied, the speed at which it falls has varied. After nine of the past 10 contractions, it took at least eight months for the unemployment rate to fall by one full percentage point. Of the 10, the fastest decline occurred after the expansion that ended in October 1949 when the unemployment rate measured 7.9%. In one year's time, it dropped by 3.7 percentage points to 4.2%. The slowest decline occurred after the recession that ended in November 2001 when the unemployment rate was 5.5%, the lowest rate recorded at the start of any expansion. About 3½ years elapsed (June 2005) before the unemployment rate fell just one-half of a percentage point. In contrast, the expansion that followed the July 1981-November 1982 contraction began with the highest unemployment rate of the postwar period at 10.8%. In that case, it took only eight months for the unemployment rate to fall more than one percentage point. 

From a policy perspective, what matters for a sustainable reduction in the unemployment rate is the growth rate of potential output. Potential output is a measure of the economy's capacity to produce goods and services when resources (e.g., labor) are fully utilized. The rate of growth of potential gross domestic product (GDP) is a function of the growth rate of potential productivity and the labor supply when the economy is at full employment. If, as recently estimated, the growth rate of potential output is as low as 2% to 2.4%., then real economic growth would not have to be much above that to yield a declining unemployment rate. How much it is above that range will determine the speed with which the unemployment rate declines during the recovery from the recession that began in December 2007. 

This report examines the relationship between economic growth and the unemployment rate to anticipate possible future developments.

Date of Report: August 20, 2010
Number of Pages: 11
Order Number: R40925
Price: $29.95

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