Unemployment Is Considered to Be a Lagging

Unemployment is considered to be a lagging indicator, but even so it would seem that the unemployment rate should be dropping faster than it is, now that economic recovery is underway. The current unemployment rate in the United States is 7.3%, up from 7.2% the month previous but otherwise at the lowest level since late 2008. This level is much higher than the pre-recession norm of 5% or lower

Whether unemployment is lagging too much or not is a question that cannot be answered without a benchmark. We know that the stock market is a proxy for economic activity, but as a leading indicator it is quite removed from the unemployment rate. Furthermore, many U.S. companies do a lot of business internationally. The success of Starbucks in China will move the stock but has nothing to do with U.S. unemployment. So GDP tends to be one of the best benchmarks for unemployment.

The recession that created the spike in unemployment also reduced U.S. GDP and when GDP growth came back, it was at a lower rate than before. Thus, the actual GDP was well below potential GDP. The way the job market works is that every year, new graduates and new immigrants enter the workforce, while retirees leave the workforce, give or take a few other people. So the supply of new labor into the workforce is predictable, and in most years it is growing. If the economy is in a state of equilibrium, this number of new workers should roughly match the combination of retiring workers and new positions created. In that equilibrium state, the unemployment rate will fluctuate a little bit, but stay within a range. While the number of immigrants is controlled by government, the number of graduates is not. So for the last several years the baby boom echo generation has been entering the workforce but their parents, the boomers, have not been exiting en mass yet. The first boomers are only now turning 65 so retirement thus far has been early for the boomers. As such, the number of workers in the workforce should have been increasing. If the economy is growing rapidly, as it was in the mid-2000s, it should absorb these additional workers. When the economy slows, it cannot absorb them and the unemployment rate spikes.

The problem with our recovery is that in GDP terms, it has been soft. The Cleveland Fed illustrates the gap between actual GDP and potential GDP. While the GDP is growing, the economy is far below potential output. Thus, the economy has a new equilibrium point for unemployment. It is not known yet exactly what that point is, but it will be higher than 5%. As a result, the U.S. economy has not returned to full unemployment

. It will not return to full unemployment by the old equilibrium standard until actual GDP gets back to the level of the pre-recession potential GDP.

This is also explained in terms of potential output by the Congressional Research Service. "If potential output growth is 2.5% annually at full employment, then the growth rate in real gross domestic product would have to be greater to yield a falling unemployment rate"