The Big Idea

It may take a tighter Fed to loosen labor

| September 9, 2022

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.

The sharp increase in the labor force in August has raised hopes that an influx of returning workers will ease the current tightness in the labor market. However, a close examination of the data suggests the August bounce in the labor force has brought labor force participation roughly back to where it should be if pandemic had never occurred.  Any further progress going forward will likely be much harder to achieve, possibly forcing the Fed further into restrictive territory.

Overall labor force participation rate

The labor force participation rate (LFPR) represents the proportion of the working-age population that is employed or actively looking for work.  A key detail that bears on the statistic is the age range of the denominator.  One might expect that the working-age population might be defined as 18 to 65, or something similar.  However, the Bureau of Labor Statistics defines the working-age population as 16 and over, which seems like a throwback to pre-modern times, before pensions and Social Security.  The lack of an upside limit means that the well-documented aging of the population, as an increasing percentage of the huge Baby Boomer cohort has reached retirement age, is impacting the aggregate LFPR.

This dynamic was in place long before the pandemic.  In fact, Fed staffers began writing academic papers on the topic around 20 years ago.  One way to quantify the impact of demographics on the LFPR is to construct a hypothetical gauge under the assumption that the population distribution remained constant over time. The BLS reports population figures and LFPRs for several age groups as well as the aggregate (16 and over) figures.  If we lock in the population proportions from one date and apply the actual historical LFPRs for each age group over time, we can create an alternative “age-constant” LFPR that shows what the LFPR would be if the age distribution of the population never changed (Exhibit 1).

Exhibit 1: Labor force participate rate and age-constant LFPR

Source: BLS, AP Sec calculations.

Popular media—and even a number of economists who should know better—have taken great comfort in the fact that the overall LFPR is still a percentage point below its February level (62.4% in August vs. 63.4% in February 2020).

However, after controlling for shifting demographics, labor force participation is nearly back to the pre-pandemic level.  From January 2010 to January 2020, the gap between the two series expanded by about 2.6 percentage points, or just over a quarter-point per year.  Since about 2.5 years have passed since the start of the pandemic, the aging of the population likely accounts for roughly two-thirds of the decline in the LFPR from February 2020 to August 2022.

That remaining one-third of a percentage point, which amounts to less than 1 million people, offers an upside limit on how many people we can reasonably expect to return to the labor force to get back to a fully normal LFPR.  Some of that group are likely people who may have retired early or made other lifestyle decisions that represent permanent choices, further narrowing the magnitude of any remaining influx.

Prime-age labor force participation rate

Another way to avoid the demographic influences upon the LFPR is to limit the focus to prime-age workers, ages 25 to 54.  Economists have increasingly shifted emphasis to this metric in recent years.  It avoids retiring Baby Boomers, early retirees (most of whom would be in the 55 to 64 cohort) and shifts by young people aged 18 to 24 choosing between work and schooling.

After a steep increase in August, the prime-age LFPR reached 82.9%, only a tenth of a percentage point below the February 2020 reading (Exhibit 2).  This measure also suggests that the pandemic effects on labor force participation have been largely unwound.

Exhibit 2: Prime-age labor force participation rate

Source: BLS.

Near-term implications for labor market

If we assume the LFPR will be roughly stable going forward, then the labor market would have to cool substantially to prevent a further decline in the jobless rate.  Given the recent trend in the working-age population, the labor force would need to rise by roughly 100,000 a month to keep the LFPR steady.  In contrast, the household survey gauge of employment has increased by 223,000 per month over the past seven months since the last annual population control revision.  If the household survey measure of employment continued to rise at that pace with a steady LFPR, then the unemployment rate would fall by 31 bp over the last four months of the year, or almost one tenth per month, and would end the year at a 70-year low of 3.4%.

Even if the pace of job gains slows, the unemployment rate could still fall noticeably.  If the household survey gauge of employment advanced on average by 150,000 a month through the end of this year, the unemployment rate would still fall to 3.5%, or roughly back to July’s cycle low.

Fed officials have made clear that the unemployment rate is already unsustainably low and needs to rise further to bring the labor market into balance.  The painless way to accomplish this would be for labor supply to surge, which may explain the frequency of upbeat speculation about a coming influx of returning workers, as we saw after the August employment report.  However, if labor supply has already essentially normalized, then the labor market is likely to remain extremely tight for the foreseeable future and may even get noticeably tighter before it turns.  All else equal, this would force the Fed to push its monetary stance further into restrictive territory than generally expected in the coming months as well as delaying the eventual reversal in policy back toward a more neutral setting.

Stephen Stanley
stephen.stanley@santander.us
1 (203) 428-2556

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