(Bloomberg View) -- U.S. central bankers seem to feel that when it comes to employment, they’ve done about as much as they can. The Federal Reserve’s Monetary Policy Report released last week concluded that the labor market was “at or a little beyond full employment.”
The Fed should approach the issue with a healthy degree of skepticism. Full employment may be more of a moving target than the central bank is willing to admit. The failure to acknowledge this could result in tighter policy than is needed. Policy makers should resist calls to speed up the pace of tightening, and investors should wait to rethink their curve flattening positions.
The most obvious sign of full employment is growth that is strong enough to pressure the Fed’s inflation target. For now, the labor market appears to be operating short of this benchmark.
An important story is not why the unemployment rate continues to be so low -- it has been for quite a while. Instead, the surprise has been the sluggish pace of compensation growth despite near-record low unemployment. Over the last three decades, an unemployment rate of 4.1 percent is consistent with compensation growth of 7.5 percent. Today, compensation growth is 2.9 percent. Against productivity growth of just over 1 percent last year, this yields unit labor cost growth of less than 2 percent, hardly a sign of incipient inflation pressure.
A critical development in recent years has been the continued rise in prime-age -- 25 to 54 -- labor force participation rates. This an area where investors and policy makers ought to keep an open mind. For example, while the overall participation rate is flat, an alternative measure that holds the distribution of the population fixed to its 2007 weights (controlling for demographic changes) has been steadily crawling back to pre-crisis levels.
Labor force participation rates are largely a structural phenomenon, a series that is moving in long waves. The most notable move was from the mid-1960s to 2000 as women joined the workforce. Since then, the participation has trended down, in part due to a rise in worker retirements. The cyclical component appears to be quite modest. That is, participation rates would be expected to move around business cycle turning points, rising during expansions and fall during recessions.
Importantly, the cyclical component appears to be growing in importance, as a recent study from the Kansas City Fed argues. Doing a bit of statistical work, the economists make two important findings. First, the cyclical drop in the participation rate was unusually large in the last recession. As the figure below shows, the participation rate fell roughly 1.5 percentage points below trend and has only returned to trend recently, or zero in our figure. Usually in an expansion the participation rate rises above trend for a period of time. We have yet to see this in this current cycle. Second, changes in the participation rate have become more pro-cyclical in recent years -- that is, more responsive to changes in growth.
The increasing cyclicality of a factor like labor force participation reflects the changing nature of the U.S. labor market, which is much more flexible today than in prior decades, when labor hoarding was far more prevalent. In a flexible labor market, wages adjust more quickly to economic conditions. So, during an economic slump, wages could discourage labor force participation since lower real wages provide a disincentive to work. In a rigid labor market, the opposite would be true. Wage rigidity would tend to push up labor force participation even during an economic downturn.
In short, the concept of full employment seems to be fluid. Given the increased sensitivity of the participation rate to economic growth, there is a good chance the rate, especially for prime-age workers, will keep climbing in the quarters ahead. Aggregate demand is likely picking up, but this could do more to lift supply than currently appreciated. If true, potential growth should be higher, the Fed can move more slowly to the exits, and longer-term rates should rise.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Neil Dutta is the head of economics at Renaissance Macro Research, responsible for analyzing global trends and cross-market investment themes.
For more columns from Bloomberg View, visit http://www.bloomberg.com/view.
©2018 Bloomberg L.P.