The Fed And The Labor Force Participation Conundrum

One of the biggest conundrums facing Janet Yellen and the Fed is whether the current unemployment rate which has been bouncing around in the high 4% range for the last few months represents the fact that the US economy is basically at “full employment’. If that is true, then a growing economy should see signs of wage inflation, prompting a faster rise in interest rates from the Fed. And there are some signs that wages are starting to rise with some regularity. If, however, we are not at full employment, then the Fed can continue to keep rates low and new jobs will be filled by the pool of workers who have given up seeking a job but may now re-enter the workforce, reducing unemployment further.

I don’t really want to delve into the question of why rising worker wages could not be tolerated for an extended period, considering they really haven’t budged in nearly 30 years. That would only make sense to me. I’d rather focus on the two views of the conundrum that Yellen and the Fed face. And the question largely revolves around the sustained drop in the prime age (25-64) labor force participation rate. Here is the trend for the last ten years:

//fred.stlouisfed.org/graph/graph-landing.php?g=cRrF&width=670&height=475As you can see, the rate has dropped from about 83.5% to nearly 80.5% over the last decade before recently recovering to 81.5%. Dean Baker points out that this is dramatically lower than projections economists made back in 2007. The current labor force participation rate for prime age men and women is nowhere near what it was expected to be, as the following two graphs show:

The current participation rate is anywhere between two and three percentage points lower than the CBO or BLS projections anticipated. Baker contends, with good reason, to believe the projections which implies that there is still plenty of slack in the workforce and that there are still plenty of people out there to fill the new jobs that are being created without a dramatic rise in wage inflation.

The other point of view is expressed in a recent report issued by Goldman Sachs, although it was comparing labor force participation in the US to other countries. The Goldman report points to three drivers of the lower labor participation rate. “First, higher rates of pain-killer use and middle-age mortality suggest that more severe health and drug-related problems have contributed to lower US participation. Second, the US incarcerates a much larger share of its population, and the challenges of finding employment faced by people with criminal records also likely contributed. Third, while exposure to trade and technology were largely similar, a weaker US policy response – namely less supportive retraining and job-search assistance – might have made the impact on participation more costly.” If the labor participation rate is below expectations for these kind of reasons, then there really is not a lot of slack in the economy and inflation may start to rise more quickly.

The question for Yellen and her compatriots at the Fed, is which one of these stories to believe. The answer may well determine the direction of the economy and the failure or success of the Trump administration’s economic policies.