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The Fed’s move to outcome-based forward guidance, and the use of the unemployment rate as a threshold indicator, shines a spotlight on the proper measure of unemployment. Recall that the unemployment rate is the percent of the labor force that is unemployed. The size of the labor force depends on the labor force participation rate (LFPR); i.e., the percent of civilian non-institutional population that is either working or wishes to work. Thus, forecasts for the unemployment rate must also include an assumption about the participation rate.
Forecasting changes in the participation rate is more difficult than normal because it is dropping for two different reasons. On the cyclical side, an unusually large number of people dropped out of the labor force during and after the Great Recession. This component of the participation rate is procyclical and should rebound as the economy recovers. However, the demographic factors will continue to exert downward pressure on the participation rate. The Congressional Budget Office (CBO) predicts that an aging population will depress the equilibrium participation rate by another two percentage points by 2020.
Will the cyclical recovery in the next few years be able to outweigh structural forces? According to our model, it would require very strong growth, closing the output gap by the end of 2014, for the participation rate to rise modestly. If the output gap is assumed to close in 2015 or later, then the structural downtrend will dominate the cyclical effect and the participation rate will be flat or slightly lower.
As noted in previous research, one key problem is that it is quite feasible that the unemployment rate threshold is crossed long before the job market is healthy. It could turn out that the participation rate continues to fall, which allows the unemployment rate to fall, even without a meaningful pickup in job creation. In other words, the official unemployment rate could reach the Fed’s 6.5% threshold, or even full employment at 5.5%, but there could still be plentiful under-employment.
This highlights that the evolution of labor force participation will be critical in judging whether incoming payroll reports are “strong” or “weak”.
This post was originally published by the BCA Research blog.