In the USA, the rate of unemployment in May 2014 is 6.3%. Two years ago, we foresaw the rate to fall down to 6% [±0.4%] in the fourth quarter of 2013 or in the first quarter of 2014. According to our model, this dramatic fall from the level observed in 2012 is driven by the change in labor force and inflation. We foresee the rate of unemployment to fall down to 3% [±0.4%] in the beginning of 2015. In this post, we discuss the bottom rate of unemployment. The USA will meet a new situation with the smallest rate of unemployment since the late 1960s and low inflation. The performance of our original model is exiting.
In 2006, we developed three individual empirical relationships between the rate of unemployment, u(t), price inflation, p(t), and the change rate of labour force, LF(t), in the United States. We also revealed a general relationship balancing all three variables. Since measurement (including definition) errors in all three variables are independent it may so happen that they cancel each other (destructive interference) and the general relationship might have better statistical properties than the individual ones. For the USA, the best fit model for annual estimates was a follows:
u(t) = p(t-2.5) + 2.5dLF(t-5)/dtLF(t-5) + 0.0585 (1)
where inflation (CPI) leads unemployment by 2.5 years (30 months) and the change in labor force leads by 5 years (60 months). We have already posted on the performance of this model several times.
For the model in this post, we use monthly estimates of the headline CPI, u, and labor force, all reported by the US Bureau of Labor Statistics. The time lags are the same as in (1) but coefficients are different since we use month to month-a-year-ago rates of growth. We have also allowed for changing inflation coefficient. The best fit models for the period after 1978 are as follows:
u(t) = 0.63p(t-2.5) + 2.0dLF(t-5)/dtLF(t-5) + 0.07; between 1978 and 2003
u(t) = 0.90p(t-2.5) + 4.0dLF(t-5)/dtLF(t-5) + 0.30; after 2003
There is a structural break in 2003 which is needed to fit the predictions and observations in Figure 1. (This break is purely artificial because it was induced by new statistics of labor force and inflation introduced in 2003 by the Bureau of Labor Statistics. The same effect was in 1978, when main definitions of labor force, unemployment, and inflation were revised.) Due to strong fluctuations in monthly estimates of labor force and CPI we have to smooth the predicted curve with MA(24). As a result, the prediction horizon decreases from 30 to 18 months.
Figure 1 depicts the predicted and observed rate of unemployment since the beginning of the 1960s. Figure 2 depicts the observed and predicted rate of unemployment since 2000, including a forecast for the next 18 months. The model showed that the unemployment rate will fall to 3.0 % in the beginning of 2015. For 119 observations since 2003, the modelling error is 0.4% with the precision of unemployment rate measurement of 0.2% (Census Bureau estimates in Technical Paper 66). Hence, one may expect 3.0% [±0.4%].
Figure 1. Observed and predicted rate of unemployment in the USA.
Figures 2. The predicted rate of unemployment. We expect this rate to fall down to 3.0% [±0.4%] in the beginning 2015.