With Federal Reserve officials scheduled today to issue its latest readout on the U.S. economy, a key theme at the central bank's two-day policy meeting is almost certainly how much economic "slack" remains. But what, exactly, is slack, and how is it measured? How much uncertainty is there about this measurement? And what does the current degree of slack in the economy tell us about how the Fed is thinking about monetary policy?
The amount of slack in the economy is essentially a measure of the quantity of unemployed resources. It represents the quantity of labor and capital that could be employed productively, but isn't; instead, it is idle. More formally, it is defined as the difference between the economy's productive capacity -- the amount of goods and services that could be produced if all labor and capital were fully and efficiently employed -- and the actual level of economic output.
When this gap is large, there is a lot of slack in the economy and monetary policy should be aggressive. But when the gap narrows, policy should ease to prevent overheating and inflation.
Unfortunately, measuring the economy's potential is not an easy task. For example, what level of capacity utilization and what level of unemployment are consistent with the full employment of resources? Presently, for example, the unemployment rate is 6.1 percent. But how far is this from full employment? Should we consider, say, 6 percent as full employment, in which case we are nearly there, or is 5 percent the right target for the unemployment rate?
This is essentially a question about how much of the current unemployment is due to structural factors -- meaning those that cannot be affected by policy actions -- and how much is cyclical, which can be changed through effective policy. Most estimates, along with the actions of policymakers, seem to suggest that we still have a ways to go before we reach full employment.
The economy's potential is also affected by the size of the labor force, and this is one of the big uncertainties going forward. During the Great Recession, many people dropped out of the labor force. Some of the exits were due to demographic factors and our aging workforce, and some were due to the economic downturn as workers got discouraged and quit seeking work. Determining the number of workers who will return to the workforce as conditions improve has been difficult, and most estimates have a strong measure of uncertainty. But recent economic research suggests that many long-term unemployed might never find a path back into the labor force.
While these is quite a bit of uncertainty surrounding both the size of the workforce and the correct target for the unemployment rate, there is another way to gauge the amount of slack in labor markets: changes in real wages. If, in fact, the economy is nearing full employment, then it will be difficult for firms to attract the workers they need either from the pool of existing unemployed or by inducing people to reenter the workforce, and wages will begin rising.
Policymakers keep a close eye on real wage rates to get a sense of how much slack there is in the labor market. Presently, wages show no signs of the types of increases that would be expected if the slack in the labor market was nearly eliminated, and this is one of the reasons policymakers at the Fed have not yet begun to reverse policy either by increasing interest rates or fully ending their purchases of financial assets. We are getting there, slowly, but we aren't there yet.