Where’s Labor Force Participation Heading?

Since shortly before the Great Recession, the labor force participation rate has fallen roughly 2¾ percentage points, allowing an unexpectedly sharp drop in the unemployment rate despite anemic growth of employment during the ensuing recovery.  Identifying and projecting the sources of recent changes in participation is especially important now because the FOMC has identified an unemployment rate of 6.5% as one threshold for raising the federal funds rate.

  • Fifty-five percent of the recent decline in the participation rate is due to structural factors that, on balance, will continue to exert downward pressure on participation through 2015.
  • The other forty-five percent is cyclical and will gradually abate.  However, the cyclical decline in participation has been larger and more persistent than in past cycles due to the unusually large increase in the average duration of unemployment during this cyclical episode.
  • Going forward, the cyclical rebound in participation will roughly offset the continuing downward push of structural forces.  Consequently, we project that in 2015, when the FOMC will be contemplating the first increase in the federal funds rate, the participation rate will be 63.4%, the same as in the second quarter of this year.

That projection for the participation rate implies that monthly changes in household employment averaging about 114,000 will be sufficient to stabilize the unemployment rate through 2015.  Anything faster will push the unemployment rate down.  To reach the FOMC’s threshold unemployment rate of 6.5% in the second quarter of 2015, as shown in our forecast, requires monthly changes in household employment averaging roughly 170,000 over the next 24 months, consistent with our forecast that monthly changes in establishment employment will average roughly 190,000 over that same period.[1]

 

UPDATING RESEARCH

Since the second quarter of 2006, the labor force participation rate has fallen from 66.1% to 63.4% in the second quarter of this year, a drop of 2¾ percentage points.   Predictable shifts in demographics and usual cyclical effects account for some that decline, but the extent and persistence of the recent drop has sent surprised forecasters in search of an explanation. We are no exception.  Chart 1 compares the observed participation rate (heavy blue line) to the fitted value from the “old” equation currently incorporated in our macro model.[2]  Through the Great Recession that equation tracked the decline in participation well, but as the recovery unfolded the participation rate kept falling while the equation anticipated that the participation rate would level out close to 65%. That specification explains less than half of the decline since late 2006. (See Table 1, Column 1).[3]

Given the failure of the old equation to explain the decline fully, we’ve updated our equation for the participation rate.  The fit of the updated equation is shown as the dashed line in Chart 1.  While these results remain preliminary, our new equation fully explains the recent decline in participation. The updated equation includes both structural and cyclical factors.  The decomposition of recent participation rates into the structural and cyclical factors components is depicted in Chart 2.

 

 

 

 

This is an excerpt from a commentary that was published on July 17, 2013.  For more information, contact Macroeconomic Advisers at (314)721-4747.

 

 

[1] Our “target” equation shows that non-farm establishment employment has grown secularly about 0.2% per year faster than household employment. Today, that translates to roughly 20,000 per month.

[2] The chart shows the old (and new) implied “target” levels of the participation rate within our error-correction model for the civilian labor force. For a description of our current methodology, please see “Good News: U.S. Labor Force Growth through 2020 Could be Faster than Widely Expected,” Macroeconomic Advisers’ Macro Focus (Volume 6, Number 5, April 26, 2011).

[3] As a consequence of this persistent over-prediction we have been adjusting down our projections of the participation rate.

 

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