Labor Market Slack And Inflation by Zach Pandl, ColumbiaManagement
Structural weakness in labor force participation means there is less slack in the labor market than commonly believed. Limited spare capacity implies earlier rate hikes and more risk that inflation eventually overshoots the Federal Reserve’s target.
Congress tasked the Federal Reserve (the Fed) with promoting “maximum employment” but left it to the central bank to decide precisely what that means. In recent decades the Fed’s practical mandate was a goal of “minimum unemployment,” with the minimum defined as the rate consistent with stable inflation. Judging by this standard, the unemployment gap today is less than one percentage point, implying a small amount of remaining labor market slack and only modest downward pressure on inflation (Exhibit 1).
However, the most recent recession and slow recovery have raised questions about whether this definition of full employment remains valid. On the one hand, an unusually large share of the unemployed have been out of work for long periods, and it’s unclear whether the long-term unemployed — who may be more marginally attached to the workforce — exert the same downward pressure on inflation as the short-term unemployed (e.g., Krueger, Cramer and Cho 20141). On the other hand, many observers see cyclical weakness in labor markets beyond unemployment – including workers on part-time schedules who would prefer full-time work and others who have dropped out of the labor force but would prefer to work if the right jobs and wages were available.
Conceptually, the Fed’s working definition of full employment will be related to the risk of overshooting the inflation target. By focusing on narrow measures of labor market slack, Fed officials will run less risk of overshooting on inflation (and some risk of undershooting). By aiming for broader measures of slack, above-target inflation becomes more likely. Exactly how much risk the Fed is taking depends on the underlying state of the economy: in particular, how much of the weakness in broader measures of labor utilization is cyclical vs. structural.
Exhibit 2 visualizes this basic idea. Along the x-axis are possible working definitions for the full employment part of the Fed’s mandate, ranging from narrow to broad. Along the y-axis is average inflation over the next several years. In the optimistic case, spare capacity remains abundant, and virtually all measures of labor underutilization exert downward pressure on inflation. In this world, it makes sense to target the broadest measures of labor market slack, because this best achieves the inflation target and maximizes welfare in the labor market. In the pessimistic case, only the narrowest measure of slack — the short-term unemployment rate — puts downward pressure on inflation. To affect a recovery in the labor market more broadly, the Fed would need to tolerate above-target inflation for a time (e.g., Rudebusch and Williams 20142). The pessimistic example includes a fat right tail on inflation for the possibility that aggressive pursuit of full employment eventually affects inflation expectations.
Unfortunately, our reading of the evidence is that the pessimistic case is closer to reality. In this report we tackle the decline in the labor force participation rate and argue that most of the recent weakness should be considered structural. But we would note that this is just one aspect of the supply-side problem. Low growth in the nation’s capital stock and soft trend productivity growth (e.g., Fernald 20144) also suggest spare capacity may be more limited than commonly believed. As a result, by targeting broader measures of underemployment, the Fed will run a higher risk of above-target inflation.
It’s unclear exactly where Fed officials stand on these issues. In public comments policymakers remain optimistic about the economy’s supply potential, and they seem to have in mind a broader full employment objective than the standard unemployment rate. However, their tolerance for overshooting the inflation target is one of the big uncertainties in the policy outlook. At the very least, some Fed officials think it would be optimal to trade a bit higher inflation for a faster recovery in employment. For instance, Chicago Fed President Charles Evans has said,5 “The surest and quickest way to reach our objectives is to be aggressive. This means, too, that we must be willing to overshoot our targets in a manageable fashion.”
While overshooting may be optimal in an economic model, it is certainly not the best case scenario for fixed-income markets. We think investors should remain cautious about U.S. interest rate risk despite strong gains in high-quality fixed income in the first half of 2014. In addition, limited spare capacity means that inflation risks have become more balanced. At current valuations, inflation-protected government bonds are more attractive than their nominal counterparts.
Labor force participation to remain low
The long-running debate around U.S. labor force participation is now very familiar to investors. Since the economy bottomed in mid-2009, real GDP has increased at an annualized rate of just 2.1%. If GDP growth could have been known in advance, standard macroeconomic models would have predicted a flat or rising unemployment rate over the last five years. Instead, after peaking at 10% in October 2009, the unemployment rate has declined to just 6.1% today. The primary reason for the steady decline has been falling labor force participation — only a portion of which can be explained by the aging of the workforce (Exhibit 3). The remaining “participation gap” has been a puzzle for economists and investors.
There are two schools of thought on how to interpret this participation gap. One camp argues that it represents cyclical weakness and should be added to the unemployment gap when estimating labor market slack (e.g., Erceg and Levin 20136). The alternative argument is that most of the decline should be interpreted as structural, because workers left the labor force for reasons unrelated to the recession and/or because cyclical weakness turned structural over time.7 In our view, the available evidence strongly supports the latter conclusion.
First, persistent weakness in labor force participation is a standard feature of recoveries after financial crises and major recessions. Exhibit 4 shows changes in labor force participation following 12 major financial crises (defined as deviations from trend in the 10 years prior to crisis). The first few are the so-called OCED Big Five financial crises. The remaining seven are from the 2008 downturn. On average, five years after the crisis year, participation rates are around 4% points lower than the precrisis trend. In the United States today, the labor force participation rate is about 3% points lower than the level in 2007. In other countries with financial crises, participation rates took a very long time to stabilize. In the Big Five sample, they remained below precrisis trends for more than 10 years after the crisis year (consistent with hysteresis effects). Academic research has found similar patterns in participation rates after other large recessions (Duval, Eris and Furceri, 20108).
Second, the composition of the recent decline in labor force participation suggests