The vanishing US labor force: New study suggests jobless rate is misleadingly low

While the unemployment rate is lower, the "real" unemployment rate is higher, the one taking into account millions of discouraged job-market dropouts. The unemployment rate is giving a misleadingly rosy signal and the Fed needs to pay close attention to the labor force participation rate as a threshold for judging the success or failure of its bond buying program.

James Pethokoukis
May 1, 2013, 11:09 am
AEI Ideas

labor force

It’s one of the biggest questions in economics right now: To what extent is the big and sustained plunge in America’s labor force participation rate — from 66% pre-recession to 63.3% now – attributable to demographics (such as an aging population) vs. cyclical factors (a weak demand economy). If it is the former, then the 7.6% unemployment rate is an OK gauge of the current health of the US labor market — could be better but improving.

But if it’s the latter, then the “real” unemployment rate — one taking into account millions of discouraged job-market dropouts — is markedly higher. The WaPo’s Jim Tankersley: “By misreading the trends in participation now, policymakers might gain a false sense of security about the state of American job creation.”

With all that in mind, Labor Force Participation and Monetary Policy in the Wake of the Great Recession, a new study from Boston Fed economists Christopher Erceg and Andrew Levin, has a worrisome finding:

Our paper provides compelling empirical evidence that cyclical factors account for the bulk of the recent decline in the labor force participation rate (henceforth LFPR). … More specifically, our analysis of state-level employment data indicates that cyclical factors can fully account for the post-2007 decline of 2 percentage points in the LFPR for prime-age adults (that is, 25 to 54 years old).

1. The Fed needs to pay close attention to the labor force participation rate as a threshold for judging the success or failure of its bond buying program. The unemployment rate is giving a misleadingly rosy signal. (And I would prefer the Fed target NGDP rather than job metrics.)

2. That being said, given the weak LFP rate, the Fed should continue to be aggressive — if not more so — in its monetary easing. As Erceg and Levin write, “The monetary rules developed for the Great Moderation period may have to be adapted to account for broader measures of slack.”

3. The Fed should be aggressive even if the unemployment rate overshoots its so-called natural rate and inflation ticks up:

A key result of our analysis is that a monetary policy can induce a more rapid closure of the participation gap through allowing the unemployment rate to overshoot its long-run natural rate (i.e,. unemployment falls below the natural rate).

Quite intuitively, keeping unemployment persistently low draws cyclical non-participants back into labor force more quickly.

Given that the cyclical non-participants exert some downward pressure on infl‡ation, some overshooting of the long-run natural rate actually turns out to be consistent with keeping in‡flation stable in our model. However, a more aggressive strategy of employment gap targeting boosts in‡flation –at least to some degree –by requiring unemployment to remain lower for even longer. Thus, there is some tradeoff between stabilizing in‡flation and broad measures of resource slack that include participation.

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