18th September 2013
Are the unemployment statistics giving a seriously misleading indication of the timetable for Fed policy normalization? Back in the 12th June weekly on this topic, I noted that: ‘The Fed has no idea how many of those workforce exiles have left for structural/demographic reasons rather than cyclical ones; if the latter is the key factor, then unemployment would probably rise in the initial stages of an accelerating recovery, as discouraged potential workers began actively looking again, and thus prolong easy policy. We won’t get a clear answer until y/y employment growth accelerates to 3-4% for several successive months, and then see if there is a strong participation rate response.’ The head of the SF Fed has recently pointed out 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. As it likely tests the 7% level by early 2014, the Fed’s hand will be forced on exiting extreme monetary stimulus…
While markets have been cheered by Larry Summers having dropping out of contention as the next Fed Chairman, inspiring hopes for a slower QE exit, the bigger issue is the underlying state of the employment market and whether it will prompt the Fed to lower its 6.5% unemployment threshold for a rate hike, which on current trends looks likely by H1 2015. A key issue for global investors to watch is the falling participation rate but also rapidly slowing workforce growth. If the same percentage of adults were in the workforce today as in January 2009, the measured unemployment rate would be 10.8%, and the Fed would be launching QE4. Over the past three months, the US has averaged 148,000 new jobs, a slower pace than the previous six months and yet the unemployment rate dropped to 7.3% in August, the lowest since December 2008, because over the summer a further 312,000 people dropped out of the workforce.
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 63.2%, driving overall economic growth and household incomes. That was largely due to women entering the labour force while improvements in healthcare allowed working lifespans to be extended. 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.
The employment/population ratio has hardly changed at all since 2009, implying that the whole of the decline in unemployment has been due to a decline in the participation ratio. Since 2000, the labour force growth rate has been steadily declining as the baby-boom generation has begun retiring and under-25s enter the workforce at a later age. Bureau of Labour Statistics and Chicago Fed researchers have forecast the participation rate to trend even lower by 2020, regardless of how well the economy does in the interim. The extent to which this workforce shift is cyclical rather than structural has huge implications for trend US wage inflation, productivity and GDP growth.
According to the February 2013 CBO estimates, potential growth of the labour supply has been slowing from 2.5% annual growth from 1974-1981 to only 0.8% from 2002-12 and is projected to slow further to only 0.6% over the next five years. At current levels, working-age population growth is at multi-decade lows. Part of that decline in working-age population growth reflects lower immigration to the US as a massive post 9/11 increase in border security spending since 9/11 has curtailed Mexican illegal immigration, and tougher visa rules have slowed legal migrant flows.
The CBO has estimated that the non-inflationary unemployment rate (NAIRU) has risen for temporary reasons to 6% of the labour force, but in the long term it will drop back to 5.5%. At the rate of jobs market progress seen recently, this implies that slack will be wholly eliminated in about 24months, implying a fairly rapid exit from the Fed’s aggressively easy monetary stance. The standard way of estimating the number of people who have temporarily withdrawn from the jobs market until it improves is to compare the actual participation rate to that predicted if the demographic composition of the workforce had remained unchanged after 2008. This method implies that about 1.3% of the labour force has dropped out since 2008, but should come back if the jobs market improves and that the amount of slack in the labour market might be at least a percentage point higher than implied by the unemployment rate. However, for several important demographic groups, there appears to have been a long term downtrend in participation rates for structural reasons unconnected to the economic cycle, while the potential supply of labour is now constrained, leaving a lot less lack in the system than many assume.