All hands on deck

| February 8, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Signs of a tightening labor market continue to pick up with the latest signal coming from labor force participation. Firms held the upper hand over workers for years after 2009 as job candidates outnumbered jobs, but leverage clearly swung to workers last year. Businesses started offering better wages, greater flexibility in work arrangements and became less picky about who they hired.  One of the primary signs that firms’ efforts have worked is a remarkable pickup in labor force participation over the past year, as workers have indeed been enticed off of the sidelines by the bidding war from those looking to hire. Wage pressure looks set to continue.

Classic reaction

Economics 101 argues that in any market where demand exceeds supply, prices need to rise to bring the market back into balance.  This simple fact explains the puzzling results of 2016 and 2017 when wages failed to pick up more dramatically despite a tightening labor market.  In reality, given the low trend rate of productivity growth, the pace of wage growth consistent with a balanced labor market is considerably lower than in past expansions, likely closer to 2% than to 3%.  Wage gains of 2.5% to 3.0% were probably consistent with a tightening labor market where workers were gaining bargaining power.

Along came 2018 and a breakout in wage advances.  The average hourly earnings gauge posted 3% year-over-year gains, beginning in August, for the first time in nearly a decade, and other hourly pay measures moved higher as well.  In fact, the average hourly earnings 12-month increase rose to 3.3% in December, with the corresponding narrower measure incorporating only production and nonsupervisory workers accelerating to 3.5% in December, although both measures came off marginally in January.

Labor force participation rates

The availability of sweeter pay drew hordes of potential workers back into the labor force in 2018.  There is a secular downtrend in the aggregate labor force participation rate (LFPR) due to the retirement of massive cohorts of Baby Boomers.  The aging of the population impacts the overall LFPR because the Labor Department defines the working-age population as all civilians aged 16 and over, excluding those in the military and prisons.  When a higher percentage of the population hits retirement, the overall LFPR goes down.

Given this secular downtrend, the fact that LFPR held roughly steady in 2015, 2016, and 2017 signaled cyclical tightening.  The structural downtrend was basically exactly offset by the upward pressure from robust labor demand, drawing people off of the sidelines.

One way to control for the effects of the aging population is to create an age-adjusted LFPR, which holds the weights of the various age groups within the overall population constant. This creates a hypothetical LFPR series under the scenario where the age distribution of the population is constant, thus isolating the cyclical influence (Exhibit 1).

Exhibit 1: Labor force participation rates: actual versus age-constant

Source: BLS, APS calculations

While the headline LFPR held relatively steady (2015-2017), the age-constant version steadily rose.  However, by 2018, the strength of the labor market proved overwhelming.  Payroll growth accelerated substantially from 179,000 a month to a stellar 223,000 a month as firms’ demand for workers ratcheted up to match the pickup in the broad economy.  The age-constant LFPR surged by three-quarters of percentage point from December 2017 through the latest observation for January to a level not seen in a decade.

Another way to filter out the influence of Baby Boomer retirements is to focus on the prime-age LFPR, which I would define as including ages 25 to 54 (Exhibit 2).  This measure has behaved similarly.

Exhibit 2: Prime-age (25-54) labor force participation rate

Source: BLS

The prime-age LFPR has also moved up by 0.7 percentage points from December 2017 through January to a level last seen in 2009.  Prime-age labor force participation has trended lower over the past 25 years, even aside from cyclical swings, as each cycle has registered lower highs and lower lows.  The trend line suggests that the degree of tightness in the labor market may be broadly in line with the top of the 2002-2007 expansion but still perhaps somewhat short of the super-tight labor market of the late-1990s.

How much further can we go?

Every month that labor force growth expands vigorously, optimists herald that it proves that there is more slack in the labor market than previously thought.  However, it seems that the opposite is true.  There is a finite pool of people who are not currently looking for work but could be drawn into the labor force.  Each month that another 300,000 or 400,000 people jump into the labor force, the remaining pool shrinks.  Of course, no one knows the size of that pool, so there is no way to be sure about how much room is left to draw in more workers.

In fact, this is not a black-and-white issue that can be settled with an equation.  Each individual not currently looking for work has a price.  For some, modestly higher wages would be enough to pull them into the workforce.  For others such as caregivers of young children and elderly retirees, the price is likely prohibitive.  As the labor market tightens, the low-hanging fruit is plucked first.  It will almost certainly get tougher for businesses to draw in large numbers of potential employees as they are forced to offer higher and higher wages and friendlier work arrangements to draw in those less inclined to work.

The working-age population is growing at a rate that suggests the pace of job growth consistent with a steady unemployment rate over time is well under 100,000 per month.  Thus, even if net hiring slows dramatically in 2019, it will almost certainly still continue to require absorbing a good deal more labor slack.

To provide some numbers, even if employment growth moderates from the stellar 2018 pace to around 175,000 a month—roughly in line with the 2017 clip—the pool of available workers will shrink by about a million, which would require some combination of higher labor force participation and lower unemployment.  If the LFPR held constant in 2019, that scenario would likely send the unemployment rate to around 3.25%, which would be the lowest reading since the Korean War and the lowest in peacetime since the 1920s. A modest decline in LFPR, consistent with no cyclical upward pressure to offset the population-driven downtrend, would dictate unemployment of about 3%.  Conversely, to keep the unemployment rate roughly steady in the 3.75% vicinity—the rise to 4.0% in January was a 1-month blip driven by the federal government shutdown—the LFPR would have to rise by about half a percentage point on top of 2018’s jump.  Either way, as long as labor demand remains robust, firms are going to have to work very hard to staff up in 2019, which means that wage gains are likely to continue accelerating.

john.killian@santander.us 1 (646) 776-7714

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