The brief holiday post last week reminded that the Federal Reserve faces a real challenge making monetary policy. The unprecedented combination of a hesitant recovery from a near-Great-Depression downturn, plus the eventual need to reverse the pedal-to-the-metal interest rates and quantitative easing, leaves the Governors and the Bank Presidents with a truly sleep-depriving responsibility.
Last week’s view was from 30,000 feet. This time, let’s focus more closely on one particular part of the Fed’s challenge – specifically, the enormous jolt that has been taken by the labor market, and most importantly the workers in it.
In the simplest terms, an appalling number of workers lost their jobs and had little or no prospect of finding new work. This situation was aggravated by the concentration of the impact on housing, in two respects. First, the housing industry itself was devastated – more so in specific localities, but by modern economic standards from sea to shining sea – meaning that if you were a construction worker, you had little hope of finding a job anywhere. As a recent post pointed out in a different context, employment in residential construction dropped by about 50 percent from its mid-decade peak, and still hasn’t recovered much. But second and more generally, the plunge in house values and housing demand has meant that any unemployed worker who found no local prospects and was willing to move to find work likely could not sell a home to do so.
The result was an enormous population of job losers with no hope and no options. Many gave up searching for work. The immediate human cost is obvious: lost incomes, lost homes, lost self-respect, lost marriages, lost skills, and children losing their optimism and vision. It seems almost heartless to turn to the economic policy challenge that flows from this catastrophe, but after all, we need sound economic policy to limit the pain.
Properly, in my view, one-half of the Federal Reserve’s policy mandate is to solve this unemployment problem. That is why it has the pedal to the metal, with its policy interest rate (the Federal Funds rate) at virtual zero, and its balance sheet augmented by purchases of longer-term assets. But to take such an extreme policy stance is to scream the question of how to get policy back to something vaguely resembling normal. Any answer to that question must rhyme chiefly with conditions in the labor market. The Fed’s fear is holding the pedal on the floor too long, and thereby igniting inflationary momentum that will require even more pain to dispel. Two-thirds of business costs come from labor. It is hard to imagine accelerating inflation without accelerating wage growth. (Zooming oil prices six years ago had nada pass-through to prices broadly.) So if the Fed can read the labor market, they are more than halfway home to reading the economy and making good monetary policy.
But reading the labor market today is extraordinarily difficult. The CliffsNotes labor market indicator, the unemployment rate, has improved at a reasonable pace – from 9.8 percent as recently as November of 2010 to 7.5 percent in April of this year. But the CliffsNotes unemployment rate won’t get you through Monetary Policy 201, even if it squeaked you past Macroeconomics 001. The reason is the exodus of workers from the labor force that we mentioned just a moment ago. Even in several recent economic recoveries, but especially in this one, improvement in the unemployment rate overstates the “improvement” – in terms of the inflation risk, the “tightening” – of the labor market. As economic conditions improve, some of the unemployed workers who have become discouraged and dropped out of the labor force will come back in and search for work – and therefore technically add to the ranks of the “unemployed.” Improvement in the unemployment rate will slow for a time, even as employment increases.
So here is the high-stakes exam question that the Fed must answer: As the economy improves, how many of those who exited the labor force will come back in, and how fast? The answer is of far more than academic importance. If this “shadow labor force” – persons not now looking for work, but who may do so if the job market brightens – is large, then there is more room for the economy to grow without triggering inflation. But if the Fed plays its cards wrong, there is a big downside. Underestimating the shadow labor force and tightening monetary policy when the labor market is deceptively loose would condemn potential workers to extended months of joblessness. But an error in the other direction is also costly; leaving monetary policy too loose as the labor market tightens would set off inflation, and force more-restrictive monetary (and perhaps fiscal) policy thereafter, causing still more hardship.
So what are the true dimensions of this shadow labor force today? Only time will tell, of course; this situation is unprecedented, and you can step into the same stream only once. But there are some signs that suggest that it could be sizeable, and that therefore the economy has considerable room to grow without inflation.
One potentially useful perspective comes from looking separately at men and women, and at different age brackets. The picture for men is probably the more telling. These data suggest that the biggest percentage jump in men not in the labor force following the onset of the economic crash came from young (age 20-29) adults (see the chart below). Anecdotally, a significant share of these young men looked at the discouraging labor market and decided to get more schooling, rather than fruitlessly pounding the pavement now to look for work that isn’t there. In any event, these young men probably are among the most likely to re-enter the work force when the job market improves. Their comparatively large numbers suggest – but certainly do not prove – a more significant upside for the labor force and for economic growth, and therefore more room for the Fed safely to maintain a stimulative monetary policy.
However, a second large source of labor market departures is older men, ages 50 and over. Because older job losers can have more difficulty finding new jobs, this isn’t surprising. For the men at the top of that age range, those departures from the labor force might turn into involuntary early retirements. To the extent that the economic crisis in effect “pre-retired” these workers, then they likely would have left the labor force soon in any event (which is why prospective employers find them less attractive, and therefore why they now have such difficulty finding new jobs), and would have more-limited impact on potential economic output, and on Fed policy. Still, these job losses are among the most painful in this sad story, and the labor-force exits among those in their 50s could be the most costly to future economic output.
The changes in labor force participation among women are more muted than those for men, but the general pattern is similar (see the following chart). There is a suggestion of younger women also postponing their entries into the labor force, possibly to complete more education; but there also are older women who may have lost their jobs and had no luck finding new ones, therefore exiting the labor force into what may become involuntary early retirement.
Again, this economic-downturn stream is very different from any into which we have stepped in living memory, and only time will tell how the labor market will evolve over the next few years. But there is some reason to hope that enough former workers will reenter the labor force to allow significant additional economic growth with only a limited risk of inflation. There are other important questions beyond the raw numbers, of course. Will some of those prospective re-entrants have lost their skills, or their attractiveness to employers? Or will some younger entrants come back from extended periods of schooling and bring augmented skills?
We cannot know the future, but we do know that Fed Governors and Bank Presidents are aware of this shadow labor force and its importance to their coming monetary policy decisions. The policymaking challenges the Fed faces truly are unprecedented – as are the challenges that face our economy itself.
Correction (July 24, 2013): The charts have been replaced to correct an error with the calibration of the vertical axes. We regret any inconvenience.