In case you missed Fed Chairman Bernanke’s speech on Monday, Okun’s Law played a key role in supporting his view of the need for the Fed to continue its easy-money policy.  But what the heck is Okun’s Law and how useful is it in the current economic environment?

In short, Okun’s Law is more of a “rule of thumb” that shows the relationship between changes in economic output (or GDP) and changes in the unemployment rate.  Developed about 50 years ago by Arthur Okun, a senior economist who served on President Kennedy’s Council of Economic Advisers, Okun’s Law attempts to specify the change in economic growth needed to translate to a one percentage point drop in the unemployment rate. 

In his speech, Bernanke referred to the graph below which plots annual changes (4^th quarter of one year to 4^th quarter of the following year) in real GDP and the unemployment rate since 1990.  The line that best fits the data is downward sloping, indicating that greater improvements in GDP (shown on the horizontal axis) are accompanied by greater drops in the unemployment rate (on the vertical axis).   So far, so good.

But what about the big deviations from the line in 2009 (shown by a pink triangle) and in 2011 (shown by a red rectangle)?  Bernanke described these data points as aberrations and warned that the recent rate of improvement in the employment situation is not sustainable unless we have greater economic growth.   The placement of the red rectangle indicates that real GDP grew about 1.6% from the 4^th quarter of 2010 to the 4^th quarter of 2011 and that the unemployment rate dropped nearly one percentage point  (from 9.6% to 8.7%) over that same period.  However, If the relationship between GDP growth and the change in unemployment had conformed to the Okun’s Law regression line (with the red rectangle higher and touching the line),  the 1.6% GDP growth would have been accompanied by a slight increase in the unemployment rate.

So how did the unemployment rate drop that much in a year of only modest economic growth?  In economics jargon, the deviation is called a “puzzle.” According to Bernanke, one of the most convincing explanations is that the 2011 aberration is the “flip side” of the 2009 aberration.  The 3 percentage point jump in the unemployment rate in 2009 was even higher than the decline in GDP would have predicted.   Employers reduced their workforces at an unusually rapid pace near the bottom of the business cycle, due partly to fears of worsening conditions and partly to constrained credit conditions.  So the 2011 aberration may represent a “catch up” from outsized job losses during and just after the recession.

Bernanke said the “catch up” period may be nearing its end and that we can’t really expect much further reduction in the unemployment rate unless the economy picks up considerably. That’s where accommodative monetary policy enters into his discussion.   The extremely low interest rates that exist today, promoted by a near-zero Fed Funds rate and massive purchases by the Fed of government debt, are intended to boost the economy by lowering the cost of borrowing.

The Fed chair, in his careful-wording style, offered a ray of hope in saying that perhaps the improvements in the labor force will boost consumer and business confidence (and translate to faster growth).  But his overall tone sounded as though he thinks the data are just as likely to indicate a continuing sluggish recovery.

Given the recent trends, I seem to be somewhat more optimistic than Chairman Bernanke.  In any case, maybe we’ll get lucky and the 2011 aberration from Okun’s Law will continue, meaning greater-than-expected declines in unemployment.