The Ongoing Economic Expansion Should Give Us 4.5% Unemployment

The economic expansion is getting stronger. Though GDP growth slowed to a 2.4 percent annual rate in the fourth quarter, the details tell a much better story. Without the large decline in government purchases in the quarter, most of which came from lower defense spending, GDP growth rate was 3.5 percent, reflecting good gains in many sectors of private demand. And we know these gains occurred in the face of severe weather disruptions in the winter months. Finally, within the private sector totals, business investment in plant and equipment rose at a brisk 7 percent rate, which is a good sign for the present expansion.

Although the current cyclical recovery of jobs and output now appears on a surer footing, there are puzzling and troublesome signs that the economy may have less room to grow from here than we had expected because the potential labor force is not growing as fast as had been projected.

The aggregate labor force participation rate—the percent of the 16 and over population that is in the labor force—is generally quite stable. It responds moderately to cyclical changes in job availability, and its trend moves only gradually with demographic changes or societal changes that affect some age cohorts. The participation rate averaged between 66.0 and 66.2 in the years 2004-2008. It has declined by 3.0 percentage points since then.

Pure demographic effects, arising mainly from the aging of the population, can account for 1 percentage point of this 3-point drop in participation since 2008. If these demographics were the only permanent effects on the trend, it would leave a 2 percentage-point drop to be accounted for by temporary cyclical effects as discouraged workers gave up looking for work. Adding those discouraged workers to those officially counted as unemployed would make today’s unemployment rate 8.5 percent rather than the 6.5 percent in the official figures.

The concern is that the recession was so deep and unemployment so prolonged that some of these former workers leave the labor market permanently. About 10 percent of the decline in participation can be identified with former workers who have filed for and are receiving disability benefits from Social Security. They are likely to remain on disability until they are eligible for retirement benefits. For some others, long unemployment spells may have reduced their job prospects even in an improved job market.

Not all the changes of recent years point to lower participation and output. In the older age groups, more workers have been staying employed in recent years rather than retiring, a trend that could continue as the job market improves. At the opposite end of the age spectrum, lower participation rates are associated with increased enrollment in college and graduate school, changes that should raise job skills and may raise participation rates of these cohorts in future years. As with the discouraged workers, the importance and permanence of any such positive developments will not be known until the economic expansion strengthens the job market much further.

So how is this uncertainty about the labor force likely to inform the conduct of policymakers? The Federal Reserve has already indicated it would maintain its present target for the federal funds rate well past when the unemployment rate reaches 6.5 percent. If the expansion continues to strengthen over coming quarters, we should expect the policy rate to begin to rise. At some point, a tighter policy will be appropriate, with the objective of a soft landing at high levels of employment. But we are still far from where inflation risks begin to dominate policy making.

During the last two cyclical expansions, the unemployment rate fell to the 4.5 percent region with little evidence of a rise in core inflation. Well before unemployment gets that low, the balance of risk and the need to avoid overshooting will lead policy to start leaning against the wind, with normal policy rates associated with high employment in the past two expansions. For now, the 4.5 percent unemployment region is a reasonable guess about where the economy could stabilize without overheating. Even with some drop in participation rates, that translates to room for years of healthy expansion from where the economy is now.