Why the U.S. jobless rate might stop falling

December 28, 2012

The U.S. jobless rate, currently at 7.7 percent, remains elevated by historical standards. But it has fallen sharply from a peak of 10 percent in October 2009. However, that decline could soon grind to a halt, according to a recent paper from the San Francisco Federal Reserve.

Its authors argue that, because the slow but steady decline in the jobless rate has been in part due to slippage in the labor participation rate that is more a product of the business cycle than long-run demographic trends, as the Bureau of Labor Statistics presumes.

In January, the U.S. Bureau of Labor Statistics significantly reduced its projections for medium-term labor force participation. The revision implies that recent participation declines have largely been due to long-term trends rather than business-cycle effects. However, as the economy recovers, some discouraged workers may return to the labor force, boosting participation beyond the Bureau’s forecast. Given current job creation rates, if workers who want a job but are not actively looking join the labor force, the unemployment rate could stop falling in the short term.

The rate of labor force participation has slid to its lowest level in 30 years.   

This means that, just as years of weak consumer spending are expected to produce some amount of pent-up demand, so too could a prolonged period of high unemployment and underemployment unleash a new burst of entrants into the job market. That would ultimately be a positive sign – but the data may not look pretty.

December numbers out next week are likely to show a slight increase in the jobless rate to 7.8 percent, according to a Reuters poll

For Mary Daly, Early Elias, Bart Hobijn and Oscar Jorda, authors of the San Francisco Fed paper, the future trend will hinge not only on the job market’s underlying strength but also importantly on participation patterns.

Nearly 6.9 million people report being out of the labor force but wanting a job. As economic conditions improve, it is reasonable to expect that some of these workers will move back into the labor force or join for the first time. Based on historical averages, about 2.1 million of them could enter the job market. These potential entrants will either take jobs directly or join the labor force as unemployed workers actively searching for jobs.

The near-term path of unemployment will reflect both how quickly potential workers enter the labor force and the rate at which jobs are created. Assume that the average pace of job creation over the past two years continues. We can then project the path of the unemployment rate over the next year according to the rate at which the 2.1 million potential workers enter the labor force.

If these workers take a year and a half to join the labor force, which would be about a year faster than the entry rate from 1994 to 1999, the recent decline in the unemployment rate would stall at more than 8% by the end of next year. Suppose though that the number of workers who want a job but are not actively looking falls at a more moderate pace and it takes three-and-a-half years for this group to join the labor force. In that case, the unemployment rate would stay at 7.7% through the end of next year. For comparison, if none of the 2.1 million potential workers were to enter the labor market, the unemployment rate would fall to 7.4% by the end of 2013. Of course, the rate at which these workers join the labor force may reflect the labor market’s overall strength. A faster rate of job creation may offset a faster rate of labor force entry, allowing the unemployment rate to fall.

What are the chances such a virtuous cycle will take place without additional policy effort? A Hamilton Project report featured here suggests it could take six more years for unemployment to come down to the Fed’s newly-established policy threshold of 6.5 percent. The central bank has said it will not begin raising rates until the jobless rate gets down to such levels, as long as the outlook for inflation remains below 2.5 percent.

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