Gavyn Davies has a great post looking at the recent work by Fed researchers and the Goldman Sachs economics team on trends in US labour force participation and their implications for US monetary policy. See also Robin Harding last month.
To recapitulate, the US unemployment rate has continued to decline steadily, and at its current pace would hit the Fed’s 6.5 per cent threshold to begin raising rates by roughly the middle of next year.
But the suggestion made by the research is that the decline in the unemployment rate perhaps projects an overly optimistic image of improvements in the labour market.
The decline has been steepened by the fall in the labour force participation rate. And the issue is mainly about the extent to which this is driven by unavoidable demographic trends (structural factors, mainly the retirement by baby boomers) versus cyclical factors related to weak demand for labour (workers who have stopped looking for a job because they expect not to find one, or workers facing high “adjustment costs” of re-entering the labour force for various reasons).
If these cyclical factors are in fact a dominant reason behind the decline in the participation rate — and this is what the studies do conclude — the unemployment rate becomes a less useful measure of slack in the labour market.
This possibility has been considered through the recovery; we discussed similar findings from Nomura more than a year ago. But the latest work is more thorough.
The relevant trend is neither easy to establish nor easy to interpret.
The Fed’s alternative U-4 unemployment measure, for instance, is meant to include both unemployed workers and those workers who have left the labour force because they were discouraged (and admitted it).
Well, U-4 has been steadily declining in recent years, just like other measures of the unemployment rate:
But the latest research from the Fed and private-sector economists has used broader measures to capture the two groups above, plus anyone else who has left the labour force for non-demographic reasons.
In support of the conclusion that the labour force participation rate is falling for reasons other than just demographics, you can see charts like this one from Nomura…
or this one from Goldman…
If the participation rate were at the higher percentage shown in the alternative line above, millions more Americans would be counted as being in the labour force and seeking work — by Goldman’s count, another 3.5 million — and the unemployment rate would consequently be higher.
As Robin explains:
[The Fed economists] split the “employment gap” — the gap between current employment and maximum possible employment — into an “unemployment gap” and a “participation gap”. …
In other words, the bigger part of the current gap between actual and maximum possible employment now is due to low levels of labour market participation, not high unemployment.
If correct, then the Fed is missing the mark on its mandate of “maximum employment” by even more than is widely understood, and the return of these workers to the labour force as the recovery continues could also continue to exert downward pressure on wages (and thus on inflation generally) for years.
Here is Gavyn’s conclusion:
What does this imply for policy? It implies that the Fed will have a bias to keep policy aggressively easy long after the unemployment rate has fallen below 6.5 per cent, and even after it has fallen below the estimated natural rate of 5.25 to 6 per cent, provided that the inflation threshold is still intact. This is because the reserve army of disguised unemployed people will exert a downward force on inflation which will not be correctly picked up by the official unemployment statistics. In a nutshell, when official unemployment is reported to be (say) 4.5 per cent, the genuine rate may still be around 6 to 6.5 per cent. Policy needs to be adjusted for that.
And from the Goldman research note, a few options:
The more immediate implication is that Fed officials may need to revisit their forward guidance. In principle, we see three options for what they might do, in increasing order of aggressiveness.
1. Emphasize that 6.5% only a threshold. They could emphasize even more that the 6.5% figure is only a necessary but not sufficient condition for a hike. This is the simplest option because it does not require agreement on a new measure, but it would make forward guidance a less and less powerful instrument of monetary policy and thereby violate the principles laid out in Michael Woodford’s 2012 Jackson Hole Paper on monetary policy accommodation at the zero bound, which seem to enjoy widespread acceptance among many FOMC members.
2. Change the number. They could lower the 6.5% threshold while keeping the focus on the unemployment rate. This would be a pragmatic way of adjusting the current approach for the participation issue without having to introduce new and less widely followed labor market indicators into the FOMC statement.
3. Change the measure. They could directly couch their guidance in terms of the employment/population ratio (presumably adjusted for the effects of population aging), our total employment gap shown in Exhibit 8, or a participation-gap adjusted unemployment rate. This directly addresses the underlying issue, namely that the unemployment rate has become a less useful statistic. But it would be considerably more complicated in terms of communication.
The three options bring their respective difficulties. One that applies to all of them would be the need to generate sufficient internal support on the FOMC against a backdrop of continued improvement in the labour market — especially if inflation has recovered somewhat or if concerns about financial instability, asset market distortions, and Fed credibility persist. (NB: this is separate from the discussion of whether any of the concerns is actually valid.)
Then again, part of the issue here is that if indeed there is more labour market slack than the unemployment rate is suggesting, then inflation will continue to be very low and inflation expectations will also remain muted. Changing the threshold won’t appear so radical, then. Maybe.
As usual, the rather large caveat is simply that the above conclusions about the inadequacy of the unemployment rate could be wrong.
But if they’re not, then it means monetary policy right now is biased towards being tighter than it should be, calibrated to address the problems of a labour market better than the one that actually exists.
