The funny concept, the NAIRU, features in the budget papers with quite a role, certainly a major supporting role if not the star role. Many of the assumptions in the budget papers reflect the role of an unobservable and mythical NAIRU. So, what is the NAIRU and how does it influence things?

The NAIRU stands for the “Non-Accelerating Inflation Rate of Unemployment”. The government believes that if unemployment is below 4.25% there will be “higher wage and price growth” and above that there will be “lower wage and price growth”.

The budget papers make it clear the government uses the NAIRU in its forecasts for the economy generally and such things as inflation in particular. The problem the government has is that estimates of the NAIRU are subject to a lot of error and indeed, there are doubts about the very legitimacy of the concept. We discuss those in detail.

Figure 1 allows us to appreciate the importance of the assumptions about the size of the NAIRU by comparing the two projections for consumer prices under three scenarios. This graph is copied from Budget Paper No 1. The scenario showing the highest trend assumes a NAIRU at 4.75%. The bottom assumes it is 3.75% while the middle is the budget assumption of 4.25%.

From Figure 1 it can be appreciated that there is a 0.8% difference in inflation between the top and bottom scenarios. So, if the budget assumption is wrong and the “true” NAIRU is 4.75%, then inflation will be 0.4% higher than if the budget assumption is correct. Putting that differently, lower unemployment by 1% raises inflation by 0.8% suggesting quite a steep relationship between inflation and unemployment. Modern experience and research shows that the relationship is more likely to be flat meaning that the lower unemployment has virtually no impact on the rate of inflation.

The implications for inflation are also spelt out for wage increases. However, in this case the impact is supposed to be even stronger; a 1% movement of the unemployment rate below the NAIRU is supposed to be associated with a 1.5% increase in wages. That is an extraordinarily high impact on wages for a modest change in the unemployment rate.

So, we would suggest the government is in error in believing in concepts such as the NAIRU and, further, in using that concept to believe there is a strong relationship between unemployment and both inflation and wage increases. That is a very large burden to put on a very flimsy concept such as the NAIRU.