How Far Are We From Full Employment?

Last week the Fed announced it was not yet ready to taper down its bond purchases. Should markets have been surprised? The Fed, in effect, was saying that inflation is not a problem and a still weak job market still calls for maximum easing. Is there reason to believe we are nearer full employment than the Fed believes and that a move toward a “less easy” policy is in order?

Some economic analysts suggest that a meaningful part of today’s 7.3 percent unemployment rate is somewhat structural rather than cyclical. By definition cyclical unemployment would respond readily to stronger aggregate demand while structural unemployment would not because the job openings and job seekers are not well matched in skills or are geographically separated. If much of today’s unemployment were structural, a policy that pushed aggregate demand in an attempt to reduce it would risk rising inflation. But at present, this is a hypothetical worry with little evidence to support it.

A structural problem

Some have cited long-term unemployment as evidence of a structural problem. Over one third of today’s unemployed have been looking for work for over half a year. This unusually high rate of long-term unemployment could reflect some structural mismatches. But it would also arise as a feature of purely cyclical unemployment that persisted for an extended period of inadequate aggregate demand, which is just what the US economy has been going through.

The sharp decline in labor force participation since the pre-recession years raises related questions. If the overall participation rate had remained unchanged since 2007, there would be 7 million more workers in today’s labor force. A part of this comes from trends in participation that would have occurred independently of the business cycle. The rest reflects discouraged workers who quit looking for jobs. Historically, most discouraged workers return to the work force and employment once the job market strengthens. If the weak job market continues this time, more of today’s joblessness could become structural.

Tighten prematurely?

The Federal Reserve must choose whether and when to move away from its present aggressively easy policy stance. The record of recent business cycles suggests an unemployment rate between 4 and 5 percent poses no inflationary risk from excessively tight labor markets. But if policymakers fear that an unusual part of today’s joblessness is structural, they might settle for higher unemployment and tighten sooner.

Rather than tighten prematurely, policymakers can minimize the risk that joblessness becomes more structural by pursuing a strong expansion. Faster job creation is needed by any measure of where the economy is today. And some joblessness that might appear structural in a weak job market will respond cyclically in a strong job market. A strong expansion will show the economy has higher potential than most analysts now expect. We are still a long way from full employment.