In a couple of recent speeches over the past month in Chicago and New York, Janet Yellen, chair of the Federal Reserve, made clear that the US central bank is going to focus attention on movements in a broad variety of labour market measures.
“As the attainment of our maximum employment goal draws nearer, it will be necessary for the FOMC [Federal Open Markets Committee] to form a more nuanced judgement about when the recovery of the labour market will be materially complete,” she said in New York on 16 April.
Ms Yellen identified four main labour market factors: underemployment and especially the number of part-timers who say they would like to be full-time; long-term unemployment; the labour force participation rate (LFPR); and wages. In part this has arisen because the unemployment rate, both in the UK and the US, fell more rapidly than had been expected. Movements of these variables are going to be crucial in determining when the Fed stops its asset purchase programme, which currently involves buying $25bn (£15bn) per month of agency mortgage-backed securities and $30bn per month of longer-term Treasury securities; and after that when it finally decides to start raising interest rates.
In a new paper, the former Bank of England Monetary Policy Committee member and now president of the Peterson Institute, Adam Posen, and I examined the implications of this unprecedented fall in the participation rate and found that it has major implications for Fed policy.* In the US the decline in the participation rate has been dramatic. The charts plot movements in the participation rate for those aged 16 and over in both the UK and the US for men and women. The participation rate is defined as the workforce, which is the number of unemployed plus the employed, divided by the population. It includes people out of the labour force such as students, home-makers and the retired.Of particular note is the fact that, for both men and women, until very recently, US rates were above UK rates. But the situation reversed in 2013. In the case of females there has been a steady rise in the participation rate since 1992, but in the US the upward trend that started immediately after the Second World War flattened out from around 2000 and then started to decline, with the rate of that decline accelerating with the onset of recession in 2009.
In the case of men, the series declines steadily in the US especially after 2008, while in the UK it declines through the onset of recession and then remains broadly flat. It should be noted we have data for the US up to March 2014, whereas we only have it for the UK for December 2013 because the UK under invests in its labour market statistics which are less timely and of poorer quality than the equivalent US data.
Adam and I found that low and falling participation in the US is indeed an additional measure of labour market slack, pushing down on US wages, just as unemployment does. A substantial portion of those American workers who became inactive, in our view, should not be treated as gone forever, but should be expected to spring back into the labour market if demand rises to create jobs. If, as we show, the market wage is driven down when there are more inactives, then clearly those inactives are still part of the labour supply. If they were truly inactive, their local presence would have no impact on local wages. Plus if the labour force overall was truly shrinking because of demographics, the general effect should be upward pressure on wages – which we do not see.
Our findings also argue against the growing sense of pessimism that the recent decline in LFPR is largely irreversible. For example, the Congressional Budget Office projects that the LFPR will edge down only slightly over the next several years, falling to 62.5 per cent by the end of 2017, compared to 62.9 per cent in the fourth quarter of 2013. Our analysis also provides strong empirical support for the assessment that continuing labour market slack is a key reason for the persistent shortfall in inflation relative to the FOMC’s 2 per cent inflation goal. In other words, the inactivity rate is relevant for both parts of the dual mandate.
As Ms Yellen said in her Chicago speech on 31 March: “The decline in unemployment has not helped raise wages for workers as in past recoveries. Workers in a slack market have little leverage to demand raises... Wage growth for most workers was modest for a couple of decades before the recession, due to globalisation and other factors beyond the level of economic activity, and those forces are undoubtedly still relevant. But labour market slack has also surely been a factor in holding down compensation. The low rate of wage growth is, to me, another sign that the Fed’s job is not yet done.”
Adam and I argue that wage inflation should be used as an additional target for monetary policy by the FOMC. Unemployment has long been known to have severe problems as a guide post to monetary policy. By comparison, a general measure of the wage inflation rate encompasses most of the relevant indictors. If mismatch or demographic shifts limit the level of appropriate workers to below the level of demand, wages should be seen to be rising.
If, on the other hand, individuals are eager for more hours, or to return to the workforce, wages should be falling on average for the whole economy. So the FOMC, we argue, should set its forward guidance for the real economy in terms of wage growth, allowing the economy to recover until wage inflation indicates that labour slack has been absorbed.
Labour market slack in the US economy remains substantial, and subject to partial control by monetary policy. Wage inflation, we believe, should be considered as the primary target of FOMC policy with respect to the employment stabilisation side of the Fed’s dual mandate. Unlike unemployment, the rate of wage inflation requires less judgement and is subject to less distortion by such factors as inactivity.
*Adam Posen and David Blanchflower ‘Wages and Labor Market Slack: Making the Dual Mandate Operational’, Peterson Institute for International Economics