U.S. Labor Market: How Much ‘Room to Run’?

U.S. Labor Market: How Much ‘Room to Run’?

Recently, Fed officials have trained a lens on the labor force participation rate, which has risen 0.5 percentage point (ppt) over the past year. The rise has occurred despite demographic and other secular trends implying that it should have declined about 0.3 ppt, including people retiring later, young adults staying in school longer and lower participation from prime-age men (due to disability or skills mismatches).

The uptick is welcome news for policymakers, as it is consistent with previous projections that a strengthening labor market would prompt an increase in labor force participation among individuals who, discouraged by their prospects, had previously stopped looking for work. During the news conference following the Federal Reserve’s September meeting, chair Janet Yellen highlighted this development as a reason to believe there is more slack in the labor market than previously thought – giving policymakers “more room to run.”

But does this assessment reflect the full picture of the increase in labor force participation? After digging into the details, we believe recent developments in the labor market may actually indicate declining and more limited slack. This is consistent with some acceleration in various wage inflation measures.

How much slack?

The amount of slack in the labor market has been a key question for policymakers since the 2008 financial crisis. Unemployment increased dramatically in its wake, but so did other measures of labor market underutilization: The number of “underemployed” (those working part-time because they couldn’t find full-time work) and the “marginally attached” (those who wanted to work but stopped looking after being discouraged by their prospects) also rose steeply.

This led many economists and Fed officials to question whether the unemployment rate alone reflected the true underutilization in labor markets. Since that time, measures of underemployed and marginally attached individuals have been scrutinized alongside the unemployment and labor force participation rates to gain a fuller understanding of labor market slack.

It is within this context that the recent rise in the participation rate has come into focus. But it’s important to examine the factors driving it. The aggregate gross labor market flows data from the Current Population Survey (CPS) indicate that the rise is not primarily the result of previously discouraged workers reentering the labor force; rather, it stems in large part from a decline in the number of long-term unemployed individuals (25- to 54-year-olds) dropping out. Notably, the decline comes on the heels of a very elevated pace of dropouts from these individuals in 2014 and 2015, suggesting only limited scope for additional improvement.

On the surface, it’s a good sign that people who would have otherwise dropped out of the labor market are now looking for a job longer. Perhaps a strong labor market has increased confidence about finding work. However, it’s important to note that the CPS data also suggest that the probability of a long-term unemployed individual finding a job hasn’t increased materially. Furthermore, the number of marginally attached and underemployed individuals as a percentage of the working-age population hasn’t declined significantly since the participation rate started to increase last year. And this development could suggest there is less slack from these pockets of the labor market than originally thought.

The participation rate trend may reverse

Taken together, these developments could indicate declining and more limited labor market slack. The factors behind the recent uptick in participation appear to have run their course. And the steady improvement in measures of underemployed and marginally attached since 2011 has stopped over the last year.

With respect to the participation rate, we believe the demographic and other secular forces that have driven trend declines in the participation rate will likely take over again (see chart). Although we can’t rule out another run of participation rate increases next year if people begin to return to the labor market, we view participation rate trends as a downside risk to our forecast for two to three hikes in the federal funds rate by the end of 2017.

48162-us-labor-blog-wilding-chart

Tiffany Wilding is a PIMCO economist focusing on the U.S. and is a regular contributor to the PIMCO Blog.