So many workers have left the U.S. job market in recent years that the decline in the official unemployment rate to 7.4 percent last month may understate the extent of weakness in employment prospects.
This gives Federal Reserve officials considerable room to keep interest rates near zero, potentially well beyond current expectations of rate increases beginning in 2015.
Combined with low inflation, a more aggressive Fed might actually see depressed rates of participation in the job market as an impetus for further monetary easing, particularly if they think more working-age Americans have simply given up looking for work after repeated rejections.
For now, officials seem gun-shy about further purchases of U.S. Treasuries and other assets, a practice designed to stimulate the economy by driving down long-term interest rates, and appear inclined to decrease them later this year.
A sharp retreat in U.S. labor force participation coincided with the start of the global financial crisis in mid-2007 and accelerated a downward trend that was already in place, for reasons economists do not yet fully understand.
The participation rate, which measures the ratio between people in paid work and the working-age population as a whole, peaked in 2000 above 67 percent and then fell steadily over the following decade. The financial crisis accelerated the decline.
The rate fell again last month, to 63.4 percent from 63.5 percent in June, as the jobless rate fell to 7.4 percent from 7.6 percent. Economists say the fall in the participation rate explains a sizeable part of the reduction in unemployment, which would otherwise be higher. Some say much higher.
In fact, when U.S. labor force participation began trending lower at the turn of the century, when the stock market bubble was just about to pop, it was the reversal of a steady rise over several decades.
An economist with the Kansas City Federal Reserve Bank, Willem Van Zandweghe, said the sharp drop in participation between 2007 and 2011, in the wake of the Great Recession, was "a far bigger drop than in any previous four-year period."
Fed Chairman Ben Bernanke himself has flagged the broad weakness in employment, seen everywhere from discouraged workers dropping out of the labor force to a large and persistent problem of long-term unemployment.
The official U.S. jobless rate "if anything overstates the health of the labor market," Bernanke stated last month, adding the central bank will not automatically raise interest rates when the unemployment rate hits 6.5 percent.
Economists generally believe there is a trade-off between the two sides of the Fed's mandate for both maximum employment and stable, low inflation. Low labor-force participation means there is even more "slack" in the economy than it appears on the surface.
THINGS GO IN CYCLES
Importantly, many Fed policymakers expect that much of the decline in labor force participation seen in recent years has been due to the economic slowdown rather than less tractable factors such as hits to specific sectors, including offshore-challenged manufacturing or crisis-hit construction.
That means displaced and discouraged workers are likely to jump back into the labor pool as hiring picks up further, which may prevent the jobless rate from coming down as quickly as it might otherwise.
If the economy generates enough jobs, the workers will come: This could be the message from the recent decline in U.S. labor force participation, suggesting the Federal Reserve may have room to leave interest rates at zero, or even purchase additional assets, than is currently believed.
Over the years, the Fed has been loath to target unemployment specifically, in part because too many factors affecting the labor market lie outside its control.
However, in the current, unconventional policy environment, in which interest rates have been held near zero since late 2008, the jobless rate has taken on an even more significant role as a marker for Fed officials.
Yet in an effort to keep long-term rates low and fight persistently high unemployment, U.S. central bankers announced late last year they intended to leave interest rates near zero until the jobless rate falls all the way to 6.5 percent. That's as long as inflation is not forecast to climb above 2.5 percent, a half percentage point above the Fed's official target, over a one- to two-year period.
Behind all of the Fed's relatively complex policy threshold arrangements lies a simple goal: stimulating the economy as much as possible given the weakness of the recovery, without causing it to overheat now or in the future.
While some Fed officials, most prominently board governor Jeremy Stein and Kansas City Fed President Esther George, have expressed some concern about asset bubbles, the threat of inflation from the assets purchases known as quantitative easing appears remote for now. If anything inflation remains too low for policymakers' comfort, prompting them to flag this in particular in their July policy statement.
EASY DOES IT
Research from Fed economists Christopher Erceg and Andrew Levin suggests U.S. central bankers have even more headroom to stimulate growth than the raw unemployment figures would suggest. That's because their models find that "cyclical factors account for the bulk of the post-2007 decline in the U.S. labor force participation rate."
The paper "recommends that in the presence of a depressed labor force participation rate, the funds rate should be kept below neutral even as the unemployment rate gets back toward its natural rate," says Michael Feroli, chief U.S. economist at JP Morgan and a former Fed staffer.
Similarly, research from the Chicago Fed shows a significant portion of the decline in participation is driven by broad weakness in the business cycle rather than structural factors that are less amenable to help from monetary policy.
In an acknowledgement to the deep hole the Great Recession carved in the U.S. job market, some Fed officials say policymakers should lower the unemployment guidepost at which they will begin to consider interest rate hikes.
The president of the Minneapolis Fed, Narayana Kocherlakota, once one of the U.S. central bank's more hawkish members, had a dovish change of heart last year, and now advocates targeting 5.5 percent.
Harm Bandholz, economist at UniCredit, assesses rather alarmingly that, if it were not for the decline in labor force participation since the start of the recession, the unemployment rate would currently be well above the crisis peak of 10 percent hit in October 2009, perhaps above 11 percent.
Based on the Fed's own forecasts, unemployment will not reach the central bank's 6.5 percent threshold at which rate hikes might be considered until the middle of 2015. Even that goal post could shift.
"The fact that the lower participation rate caused a decline in the unemployment rate, which is stronger than warranted by labor market fundamentals, makes it very likely in my view that the Fed will change the unemployment rate threshold in its forward guidance from currently 6.5 percent to 6 percent or even 5.5 percent," said Bandholz. "That should signal that rate hikes remain far off.
"In other words," he added, "the Fed will largely dismiss the decline in the unemployment rate as being unwarranted."
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