Interpreting Deviations from Okun’s Law. Mary C. Daly, John Fernald, Òscar Jordà, and Fernanda Nechio

“Arthur Okun (1962) described the consistent relationship between changes in output and changes in unemployment that has become a standard tool for monetary policymakers and forecasters. The statistical relationship he uncovered has come to be known as Okun’s law. A simple form of this popular rule of thumb says that a 2% drop in inflation-adjusted GDP growth relative to trend is associated with about a 1 percentage point increase in the unemployment rate. Because of the historical stability of Okun’s law in the United States, economists often use the unemployment rate to calibrate their economic forecasts. In particular, they project that GDP growth and changes in the unemployment rate will move together at this two-to-one ratio in the future as they have on average in the past. While this is a sensible approach, it appeared to break down during the Great Recession and ensuing recovery. Unemployment rose more quickly in 2008 and 2009 than expected given the modest decline in GDP reported at the time (see, for example, Daly and Hobijn 2010). Subsequently, unemployment has fallen quickly despite fairly modest growth in GDP. This deviation from the average relationship raised questions about whether the severity of the Great Recession had fundamentally altered the underlying workings of the economy.  In this Economic Letter, we re-examine the apparent breakdown in Okun’s law and put it in the context of previous recessions and recoveries. We find that part of the apparent inconsistency in the relationship between unemployment and output dissipated once GDP data were revised. Comparing the revised estimates of Okun’s law with previous recessions, we find that temporary deviations from the average two-to-one rule of thumb are common. In fact, through this lens the 2007 episode resembles other deep recessions and slow recoveries, such as the experience during and after 1973. Our findings suggest that Okun’s law is working about the same as it always has. Moreover, temporary departures from the average relationship are part of the normal dynamic path of the economy. (See Daly, Fernald, Jordà, and Nechio 2013 for a more detailed discussion.) ”