What Is the Unemployment Rate? How Is It Calculated?

You may know the unemployment rate as the share of people in the U.S. who do not have a job – but there’s more to it than that. The unemployment rate can be a critical indicator of the health of the economy.

There are two main types of unemployment rates that people will utilize. The first is commonly referred to as the U-3 rate, or the official unemployment rate. It is the percentage of the U.S. population that is currently unemployed and has actively searched for a job within the past four weeks. This is the rate that is most often referenced.

A common criticism of the official unemployment rate is that it doesn’t accurately reflect the amount of people out of work because it only accounts for people who have actively searched for work in the past month.

For example, let’s say a person has been out of a job for two months. This person spent the entire first month looking for a job, but to no avail. The second month, this person stopped applying to jobs and simply gave up. This person is now classified as a “discouraged worker” and will not count towards the official unemployment rate.

The second type of unemployment rate is the U-6 rate or the real unemployment rate. The U-6 rate accounts for everyone included in the U-3 rate, but also expands to include all marginally attached workers, which is anyone who has looked for a job in the past 12 months, and all underemployed workers, which is anyone who works part-time involuntarily. The real unemployment rate is the most comprehensive of the rates.

We refer to the U-6 unemployment rate as the real unemployment rate because it provides us with a more accurate depiction of the amount of people that want to work but cannot find a job, whereas the U-3 has far more restrictive guidelines in who it accounts for.

There are an additional four rates that the Bureau of Labor Statistics will use to analyze unemployment statistics: the U-1 rate, U-2 rate, U-4 rate and U-5 rate. However, these rates are less commonly referenced.

What does the unemployment rate tell us?

The unemployment rate tells us the amount of resources (workers) that are not being utilized in the workforce. When the economy is expanding, and companies are growing, they hire more workers, which makes the unemployment rate decrease. However, if the economy is slowing down, and companies are closing branches and decreasing production, they will typically lay off workers, which makes the unemployment rate increase.

The unemployment rate is a lagging indicator, which means it measures the effect of events after they have already occurred.

How does the Federal Reserve use unemployment data?

The Federal Reserve uses the unemployment rate as an indicator to determine how the economy is doing. The Fed can influence employment rates through monetary policy, which is a fancy way of saying that they can enact different regulations to affect the flow of money in the economy.

The Fed can decrease unemployment by boosting economic growth through expansionary monetary policy, like increasing government spending on projects and lowering short-term interest rates.

On the other hand, if the Fed is worried that the economy is growing too quickly, it can use contractionary monetary policy to slow economic growth. If the economy is growing at an unsustainable rate, it risks becoming overheated, resulting in a spike in inflation.

Contractionary monetary policy slows growth by limiting the amount of money in the economy. The Fed can do this by raising taxes or reducing government spending. However, this can all lead to an increase in unemployment. If the government is worried the economy is expanding too rapidly and reduces government spending, a large number of people could lose their jobs. The Fed may have effectively slowed down the economy, but they also contributed to a rise in unemployment. The people who were fired will now have less disposable income to contribute back to the economy.

If layoffs are happening at a large scale, it contributes to a cycle of low consumption and high unemployment. In other words, if people aren’t buying goods and services at a steady rate, more workers get laid off. All of this may lead to a poor performing economy for the country at large.

Why do investors care about the unemployment rate?

Investors can gain a lot of valuable information from the unemployment rate. One way they can utilize the unemployment rate is by evaluating the general trends occurring: If the unemployment rate is significantly declining, they know that businesses are growing and are hiring more employees. Based on the unemployment rate in an individual market, investors can also see which sectors are losing or gaining jobs, which they can then use to help determine which sector-specific stocks, ETFs, or mutual funds to sell or buy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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