US Workforce Trends Confuse Investors…

We think that today’s labour force participation rate is about right, given observed demographic trends’ – James Bullard, St. Louis Fed President

We’ve seen a burst of volatility in the wake of the US December payrolls data, which ran contrary to just about every piece of bullish recent data and looks like an anomaly in what is a very noisy series. The slump in the labour force participation rate to 62.8% was the most interesting aspect, and it’s a sustained downtrend which has confused many observers. However, it was predicted pre-crisis by demographic models, including research done by the Fed itself. Over the past five years, the US labour force has grown only 0.2% annually, a fraction of the 1% plus pre-crisis trend. In principle, there are roughly 10m potential workers ‘missing’ from the data. If they were to suddenly reappear and actively look for a job, the unemployment rate would be closer to 11%.  The share of Americans either working or actively seeking work in December was the lowest level since 1977, before the female participation rate began to soar through the 1980s and 1990s. 

 As I’ve highlighted previously, the trend is largely structurally demographic rather than cyclically economic. Much of the decline was eminently predictable; indeed a 2006 paper by Fed economists accurately predicted that participation would fall to 62.9% by 2014. There is far too much focus on the demand side of the equation i.e. employment growth, and too little on the supply of labour which is slumping because of demographics and the end of Mexican immigration (the latter partly because of the high tech fence now blocking the border). Meantime, the US economy generated 2.2m new jobs last year, an impressive outcome set against substantial fiscal headwinds and the ever growing impact of productivity boosting technology in the service sector, adding to a similar gain in 2012.

For the Fed and investors, the question is how much of this downshift is cyclical (the still weak employment market discouraging potential workers) versus structural (i.e. demographic trends).  If the same trends in employment/population growth were in place as pre-recession, total employment would by now be about 6m higher. Between 1960 and 2000, the proportion of Americans in the workforce surged from 59% to a peak of 67.3% of the population before dropping to the current 62.8%. Recent studies have validated the 2006 predictions (and of all the data economists torture into submission, demographic trends are invariably give the most reliable answers). According to an analysis last November by an economist at the Philadelphia Fed, the aging of the American population accounts for most of the decline in labour force participation since 2000.

The head of the SF Fed pointed out back in September that the unemployment rate has consistently been the best single measure of slack in the labour market for many decades, and that it remains very closely correlated with alternative measures derived from other sources such as private employment surveys/job openings etc. While I’d expect the participation rate to bottom on a cyclical basis in Q1, and gradually pick up by a point by year-end, the fact remains that there is less slack in the US labour market than widely assumed on a ‘mean reversion’ basis for the participation rate because of structural headwinds.

For example, teenagers are spending longer in education, and male participation rates for most age groups have been declining continuously for several decades (possibly because of the evolution of the economy away from manual blue collar occupations, notably in manufacturing). The downtrend accelerates during recessions but only partially reverses during subsequent recoveries. It is very difficult for the Fed to distinguish between a permanent, structural change in the participation rate and one which will be reversed if there is a stronger recovery in the jobs market, but recent comments suggest they are leaning toward the former explanation. If the CBO/Fed estimates of the non-inflationary unemployment rate (NAIRU) are right at about 5.5%, then labour market slack will be pretty much eliminated within a couple of years even with a slight pick-up in participation, implying a fairly rapid exit from the Fed’s aggressively easy monetary stance.