There have been a number of mysteries in the evolution of the US labour market post the Great Recession. Two that remain, and were only ever going to be resolved as the cycle matured, are the relatively low level of labour productivity growth and the significant trend decline in the labour participation rate.
There has been a significant trend decline in the US unemployment rate since the peak of 10% in late 2009 to the most recent reading of 5.0% as at March this year. That has been the combined result of solid jobs growth but also helped by people dropping out of the labour force as indicated by the decline in the participation rate from around 66% prior to the recession to a recent low of 62.4% in September 2015.
To be considered part of the labour market, a person must either be employed or actively seeking work. Using 2008 as a base, that drop in the participation rate indicates around 8.5 million people have dropped out of the labour market over the last 8-years.
There are a variety of reasons for a declining participation rate with some structural (i.e. permanent) and some cyclical (i.e. temporary). Structural factors include the aging of the population and a greater proportion of young people staying in education for longer. A typical cyclical factor is the so-called “discouraged worker” effect whereby a person may be out of work, is unsuccessful at finding a job and becomes discouraged, thus ending their job search and dropping out of the labour force.
Over the last six months we have seen a significant rebound in the participation rate which as at March was back up to 63.0%. This is the equivalent of 1.5 million people returning to the labour force over that six-month period. This is the beginnings of the unwinding of the cyclical component of the decline in the participation rate as jobs have become easier to find and as wages have started to nudge higher.
The extent to which the recent decline in the participation rate is structural or cyclical is an important issue for the Federal Reserve in determining the amount of slack in the labour market and the likely future inflation pressures that may emanate from wage growth as the labour market tightens. People returning to the labour force have had the impact of stabilising the unemployment rate over the last few months. In fact it ticked higher from 4.9% in February to 5.0% in March, despite continued solid jobs growth.
The big question is how much further the participation rate may rise from here. As the decline has been debated over the years, the consensus has gravitated to the view that it has been mostly due to the large structural factors playing out, though with come cyclicality thrown in for good measure. That seems intuitively sensible to me and means the participation rate that is consistent with full employment is now lower than it used to be.
So while the participation rate may continue to move up over the next few months, we don’t expect this to be the start of an extended trend higher. That means the most prudent course of action for the FOMC is to continue the interest rate normalisation process. We’re still happy with our call of two quarter-point interest rate increases this year with the first one in June.