The US labor market: a non-consensus view

May 8, 2014 | By Ray Janssen and Jay Raol

In this paper, we offer a non-consensus assessment of the US labor market. We believe that the common dichotomy between cyclical and structural influences should be replaced by a construct examining transient and persistent factors. On this basis, we argue that most market participants underestimate US labor market tightness. Therefore, we would not be surprised to see labor related financial market volatility in the months to come and declining potential GDP growth over the next decade.

Workers are at the core of the macro economy. Labor drives economic formation and long-term appreciation of financial assets. The balance of supply and demand in the labor market is a key focus for monetary and fiscal policies, particularly in the US. Low demand relative to supply can produce high unemployment, strains on government resources and a sluggish or recessionary economy with deflationary price pressure. High demand for labor may put upward pressure on wages and propagate inflation, price instability and economic uncertainty. The US Federal Reserve (Fed) has a mandate to "promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates."1 Labor is the lynchpin of broad policy — both monetary and fiscal. In the US, it influences matters such as health care reform, immigration and the size and duration of unemployment benefits.

Labor demand ebbs and flows. Spans of rapid growth, low unemployment and rising prices interpose sluggish or recessionary periods. The Fed endeavours to mollify fluctuations and stabilize the economy over time through interest rates. The principal policy rate is the so-called "Fed funds" rate, the overnight rate at which member banks with excess reserves at a Federal Reserve District Bank lend to other member banks. Hiking this rate can reduce credit creation in periods of economic exuberance; lowering this rate can stimulate borrowing, investment, job creation, and growth in periods of weakness.

Growth and inflation typically reach extremes during economic cycles. When metrics on labor and other factors reach levels that point consistently "hot" or "cold," the Fed responds predictably, setting the interest rate dial higher or lower. However, it is the transitions that can be tricky.

We are now in transition. The US economy has emerged from the global financial crisis and the Fed is poised to move away from the "zero interest rate policy" it has maintained for five-plus years. The timing and degree to which the Fed takes its foot off the gas are now principally data-driven — largely, by labor data.

What do labor data tell us? This is the pertinent question. The US unemployment rate has shrunk to a level close to 6.5% — until the March Federal Open Market Committee (FOMC) meeting, this was the key labor threshold identified by the Fed. On the other hand, job creation has been sluggish. As the unemployment rate has fallen, so has the employment rate. In short, supply and demand are moving in the same direction. Where do supply and demand re-equilibrate? How do we interpret this phenomenon and gauge its likely impact on prices of services, goods and financial assets?

Framing responses to these questions requires an understanding of how rates of unemployment and employment can simultaneously shrink. The unemployment rate is the ratio of unemployed workers to the size of the labor force. The employment rate is the ratio of employed workers to the workingage population. The two measures can shrink simultaneously when the labor force participation rate (LFPR) shrinks, that is, when the combined employed and unemployed labor force as a percent of the working-age population declines. In the US, LFPR has been shrinking for more than a decade.

Invesco Fixed Income's research has focused on several key questions surrounding the shrinking LFPR. What is causing this trend? When and where will it end? What does it portend for labor market equilibrium and the "non-accelerating inflation rate of unemployment" (NAIRU)? Are downward drivers of LFPR cyclical or structural?

Our research reframes forward views on labor market equilibrium and its potential impact on interest rates and asset prices. We believe the key issue for investors is the persistence of shifts in the labor market. In our view there are significant asymmetries in motives for individuals entering and leaving the labor force. The lack of job prospects in a recession may lead an individual to drop out of the labor force. This is a cyclical phenomenon. However, this individual, while out of the workforce, may follow a path that precludes a return to the labor force even when the recession abates and the job market improves. In this cycle, there has not been a cyclical labor force return for every cyclical exit — that is, there has been a persistent reduction in LFPR.

In our view, there is downward pressure on the LFPR that will keep it from rebounding to the same degree as in other cyclical recoveries. Hence, we believe the unemployment rate will shrink faster than is generally expected. NAIRU, which we estimate at around 5.5%, could be reached in 2014. Consensus opinion sees the economy at NAIRU no earlier than late 2015. Hitting NAIRU sooner than expected could induce inflationary pressure on wages that may impact GDP growth, monetary policy, and asset performance. When labor markets reach threshold unemployment levels, financial markets will likely begin to anticipate and "price in" inflation pressures and changes in monetary policy. We believe economic data releases specific to the labor market and inflation indicators will take on heightened importance in the coming months and could lead to increased market volatility.

Labor participation and unemployment

The employment/population ratio and the unemployment rate measure the labor force and the aggregate economic temperature in different ways. In the numerator, the first metric has the number of employed workers and the second has the number of unemployed workers. Workers are either employed or unemployed, so as one metric goes up the other will go down, all else remaining equal. Figure 1 illustrates that changes in these two series were reliably opposed until recently. Since 2009, the unemployment rate has fallen from a 25-year high of 10% to under 7%, but rather than rising, the employment/population rate has flat-lined around 58.5%.


Sources: US Bureau of Labor Statistics, Bloomberg. Data as at February 2014.

Significantly, the two ratios in question have different denominators. The employment/population ratio (EPR) measures employed workers against the total population. The unemployment rate (UR) measures unemployed workers against the total labor force, a subset of the total population. The breakdown between EPR and UR lies in the relationship between their denominators: the total population and the total labor force. Dividing the size of the labor force by population produces an important metric known as the labor force participation rate (LFPR). Mathematically,

EPR = (1 – UR) * LFPR

Changes in the employment/population ratio and the unemployment rate exactly cancel one another when LFPR is constant. A non-constant LFPR complicates the matter.

LFPR in the United States grew in the 1970s, '80s, and '90s as steadily more baby boomers and women entered the labor force. It peaked in 2000 and has now declined steadily for more than a decade (figure 2). LFPR exhibits a trajectory more reflective of secular trends in culture and demography than of business cycles and economic vitality. The secular downtrend in LFPR is likely to persist even as economic health returns.


Sources: US Bureau of Labor Statistics, Bloomberg. Data as at February 2014.

The labor market fluctuates with economic conditions. Figure 3 depicts patterns in unemployment and LFPR from the onset of recession over the years 1949 to 2008. What is notable is that the participation rate when conditioned on the unemployment rate has exhibited much less volatility, moving less than 0.1 percentage points in either direction in the 20 quarters following the onset of a recession. We conclude that the variability in the LFPR due to cyclical factors has been minor.


Source: IMF, Invesco calculations using an approach similar to Ecreg and Levin, Labor Force Participation and Monetary Policy in the Wake of the Great Recession, 2013. Bivariate vector autoregression was estimated on the unemployment gap (unemployment rate less CBO NAIRU) and labor force participation using data from Federal Reserve Economic Data covering Q4 1949 to Q4 2013.

We further examined the LFPR in this most recent cycle. In 2007, the Bureau of Labor Statistics (BLS) produced an LFPR forecast based on demographics and trend rate economic projections. Figure 4 shows these estimates and the actual LFPR. The great financial crisis likely exacerbated the decline in LFPR, but there has not been a cyclical rebound as growth has rebounded. If LFPR explains the anomaly in the relationship between the employment/population ratio and the unemployment rate, and LFPR is cyclical, then one would expect this relationship to renormalize as the economic cycle turns and health is restored. The logic that frames the analysis into structural and cyclical components indicates that the failure of the employment /population ratio to pick up reflects continued ill health in the macro economy and, therefore, the labor force.


Source: US Bureau of Labor Statistics. Data as at January 2014.

Reframing the issue

Can we properly attribute changes in LFPR to cyclical and structural causes? This has been the crux of a large debate. It misses the mark, in our view. There are asymmetries between leaving and reentering the workforce and between jobs lost and jobs created. For instance, suppose John Doe is a mid-career professional who lost a job due to corporate downsizing in the recession. He was nominally "unemployed" for a time, but eventually gave up and left the labor force. He has been out of work for several years and has adjusted to his new lifestyle. Economic recovery ensues. New jobs exist, but a new job is not John's old job. He likely can't step back into his career at his former role, responsibility, seniority or salary. He has scant motive to start over in an entry-level position, and chooses not return to the labor force. Labor participation is down one man. Is that cyclical or structural? The cause was cyclical. The effect is structural.

Cyclical versus structural is a false dichotomy. It is useful and accurate, in our view, to instead consider transient versus persistent change. Cyclical economic factors conspire with structural factors that may be more "human" than economic. Emigration and disability benefits are further examples. For example, just under 90% of workers who begin collecting disability benefits remain permanently out of the labor force (David Autor and Mark Duggan, National Bureau of Economic Research, August 2006). In figure 5, we categorize several reasons for nonparticipation as transient (less than five years) or persistent (five years or more).


Source: Invesco, April 2014.

LFPR through the transient/persistent lens

How does the 2007 BLS forecast versus actual LFPR look from the "transient versus persistent" perspective? The Philadelphia Federal Reserve surveyed workers who left the labor force between the fourth quarter of 2007 and the end of 2013. LFPR fell 3.2% over this period. By our classification, 0.75% of this decline was due to transient factors, including being discouraged and pursuing additional education, and 2.45% was due to persistent factors (figure 6). Reframing this discussion illustrates further why we believe improved economic conditions may not lead to an increase in the LFPR.


Source: Shigeru Fujita, Philadelphia Federal Reserve (February 2014), Invesco. Data period from Q4/2007 to Q4/2013.

Implications

Our findings have clear implications for the unemployment gap, real wages, inflation, and long term GDP growth. We believe that the flat trend in the employment/population ratio is not reflective of a weak employment market. Rather, it is the result of workforce growth that is materially slower given the lower LFPR. When the cyclical improvement in the labor market subsides, we expect that the employment/population ratio will continue to drift lower.

As such, we believe that recent rate of unemployment, 6.7% at the end of February, is accurately measuring the labor situation. In our view, there are workers who will leave the labor force now that extended unemployment benefits have been eliminated, driving down both the participation rate and the unemployment rate further. However, we also think that some of these exiting workers will be offset by the return to the workforce of those workers who have been discouraged or who have been pursuing additional educational opportunities.

Our analysis indicates that the unemployment rate may hit our assumed NAIRU of 5.5% during the fourth quarter of 2014 under reasonable assumptions, including our expectation that monthly nonfarm payroll growth will be at least the 185,000 average that was achieved in the second half of 2013. Current economic forecasts are for an unemployment rate of 6.2% by the end of 2014 (Bloomberg), consistent with the Fed's forecast. We believe achieving this level ahead of Fed and market consensus clearly has implications for Fed forward guidance regarding policy and the market's response to that guidance.

It will be important, as the labor market tightens, to watch data for indications of increased wage growth. In addition, although there are still many disinflationary forces in effect, we will watch realized inflation and inflation expectations data for signs of upward pressure. The FOMC commented in their statement of March 19, 2014 that "it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored". We believe that upward movement in inflation toward the Fed's target of 2 percent will be welcomed, but the challenge will be ensuring such forces remain contained and do not result in sustained increases in inflationary expectations. Markets are aware of the challenge of walking this fine line between enough inflation and too much. How the Fed communicates its forward guidance will face critical scrutiny and has the potential to increase market volatility.

Finally, we expect the ongoing decline in LFPR to be a 0.5% headwind to US potential GDP growth for a decade or more given aging demographics. This is a shift from the 1990s when the increase in LFPR was a 0.5% tailwind to GDP growth and the 1980s when the contribution was greater than 1% (figure 7). In the 1980s, cultural change in the form of increased dual income families was a considerable factor, while both the '80s and '90s were impacted by additional baby boomers entering the work force. While we do not expect a reversal in cultural norms regarding women in the workforce, we do believe the demographic forces that benefitted growth by 0.5% in the 90s will be reversed over at least the next decade, as baby boomers continue to retire. We believe this downward trend in the LFPR is likely to persist until retirements of the baby boom generation level out over the next decade.


Source: Kevin L. Kliesen, St. Louis Federal Reserve (October 2012). Forecast by Invesco as at February 2014.

Conclusion

In summary, our analysis indicates the US labor market is tightening. A stagnant employment to population ratio is viewed by many market participants as an indication that considerable slack remains in the labor market, despite the reduction in the unemployment rate. We disagree. We place the analysis of the labor market into a framework that distinguishes persistent from temporary unemployment. Our analysis indicates that aging demographics as well as other influences are leading to a decline in the LFPR. The other influences may, in fact, be brought about by cyclical factors but persist in structural change.

Given this tightening in the labor market, NAIRU may be reached in 2014, in advance of most market participants' expectations. As such, financial markets may begin to anticipate wage pressures and other inflationary forces, "pricing in" these expectations as well as expectations for changes in monetary policy. Labor and inflation data will be scrutinized by markets, as will Fed forward policy guidance. In this environment, both data and forward guidance will have the potential to generate increased financial market volatility. Finally, given these persistent influences on the labor market, including but not limited to aging demographics, the LFPR is likely to continue to decline for a decade or more, reducing US potential GDP until the time that baby boom retirements subside and cease to offset the increased participation of the echo boom generation.

The document is intended only for Professional Clients and Financial Advisers in Continental Europe, in Dubai, Ireland, the Isle of Man, Jersey and Guernsey, and the UK for Professional Clients, in Australia for Institutional Investors, in Hong Kong for Professional Investors, in Japan for Qualified Institutional Investors, in Singapore for Institutional Investors, in Taiwan for Qualified Institutions/Sophisticated Investors and in the USA for Institutional Investors. In Canada, the document is intended only for accredited investors as defined under National Instrument 45-106. In Chile, Panama or Peru, the document is for one-to-one institutional investors only. It is not intended for and should not be distributed to, or relied upon, by the public or retail investors.

Ray Janssen, Senior Analyst, Investment Grade Credit Research
Jay Raol, Analyst, Global Quantitative Research Invesco Fixed Income

1 The Federal Reserve Act of 1977.

Important information

The document is intended only for Professional Clients and Financial Advisers in Continental Europe, in Dubai, Ireland, the Isle of Man, Jersey and Guernsey, and the UK for Professional Clients, in Australia for Institutional Investors, in Hong Kong for Professional Investors, in Japan for Qualified Institutional Investors, in Singapore for Institutional Investors, in Taiwan for Qualified Institutions/Sophisticated Investors and in the USA for Institutional Investors. In Canada, the document is intended only for accredited investors as defined under National Instrument 45-106. In Chile, Panama or Peru, the document is for one-to-one institutional investors only. It is not intended for and should not be distributed to, or relied upon, by the public or retail investors.

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