Shedding Light on the Labor Force Participation Rate

Original post on March 10th, 2014
Last Friday, February job report came with a little surprise of higher than expected job growth of 175,000 and an increase in the unemployment rate to 6.7%. The increase in the unemployment rate came from non-participants getting into labor force in last month. While we watch the FED's move to wind down QE and plan on raising the interest rate as the economy slowly recovers, we should look at more data to see whether the recovery is bringing back the U.S. economy to the track. A recovery should bring back the economy to the long run trend.

The puzzle we see after the recession is a historically low level of the labor force participation rate. The labor force participation rate is unchanged February at 63.0%, which is the lowest in 35 years. The following graph shows the labor force participation rate (LFPR) for the total population and population from age of 25 to 54.

It is now clear that the LFPR for the total population has been decreasing since the onset of the recession. This decrease has partially been linked to the baby boomers' retirement since 2010. But increasing data we see is that the LFPR for the group of age of 25 to 54, the prime age workers, has also been decreasing during the recovery. For this group, retirement is less relevant to the decreasing LFPR. Therefore, we should worry that there might be a cyclical decline in the LFPR.

Timothy Dunne and Ellie Terry have recently written on the subject of low LFPR. According to them, a decrease in the LFPR for prime age workers is a key contributing factor to the low overall LFPR. They separated the effect of a change in the LFPR of each age group on the overall LFPR change. The following chart shows how change in the LFPR decomposes:in their own words on the result:

Three key results emerge. First, increases in labor force participation for the youngest age group boosted overall labor force participation by 0.075 percentage points. Second, the growing population share of the 55+ age group reduced LFPRs over the period by 0.21 percentage points, accounting for roughly 40 percent of the overall decline. Third, labor force participation for prime-age workers continued to fall. The combined within effect for the prime-age individuals (25–34, 35–44, and 45–54) reduced the participation rate by 0.28 percentage points—or a little over half of the overall decline in labor force participation. Additional declines in labor force participation were associated with the reduction in population shares of prime age workers.

In other words, we see that much of the decline in the LFPR has come from decrease in the LFPR for workers of age of 25 to 54. For this group, the LFPR was 82.5% when the recession ended; whereas it is now 81.1%. A question we should ask is whether the labor force participation rate can get back to its highest level of above 84% once the unemployment rate reaches its natural rate and the economy recovers (we should define when a recovery ends).

From the first graph, it seems like the LFPR reached its highest level at around 66%. Considering increase in retirement of baby boomers in coming years, getting back to this level of LFPR is unlikely even after a solid recovery. However, the recovery should bring the LFPR for the prime age workers back to its pre-recession level unless there are some structural factors that are reducing the rate. There is high possibility that the LFPR for prime age workers might not reach its high level as the economy recovers and the unemployment rate decreases. In this case, Christopher J. Erceg and Andrew T. Levin have suggested the  monetary stimulus policy to continue until some other labor market conditions, specially the labor force participation rate, pick up, not just until the unemployment rate drops to low level if the LFPR is still relatively low.

Does the recent low interest rate induce more investment?

 As Keynes argued that the solution to the Great Depression was to create more investment through a reduction in interest rates, one of the goals the Fed pursued through its near zero interest rate policy was to lower overall interest rate in the economy and create more investment. As we studied from IS-LM model, I(nvestment) part of the model is a decreasing function of the real interest rate. But, of course, IS-LM model is very simplified but useful to see effects of certain changes in the economy isolated from other factors. If we naively assume the model's argument and recent economic condition since the recession, we would expect total investments to be risen since the Fed has shifted to zero interest rate policy. As the monetary policy makers lowered the interest rate to near zero, the economy has been seeing the only period of below zero real interest rate which wasn't created by high inflation as it was in the 1970's.

Historical real interest rate ( 10-year rate minus personal consumption expenditure inflation rate)

We would expect businesses to borrow money with negative real interest rate and invest it to their businesses, right? Recent research done by by Federal Reserve staff economists Steve Sharpe and Gustavo Suarez showed that businesses investors were inelastic to low interest rates. According to the paper,

The vast majority of CFOs indicate that their investment plans are quite insensitive to potential decreases in their borrowing costs. Only 8% of firms would increase investment if borrowing costs declined 100 basis points, and an additional 8% would respond to a decrease of 100 to 200 basis points.

Strikingly, 68% did not expect any decline in interest rates would induce more investment.

In addition, we find that firms expect to be somewhat more sensitive to an increase in interest rates. Still, only 16% of firms would reduce investment in response to a 100 basis point increase, and another 15% would respond to an increase of 100 to 200 basis points.

Read more: http://www.businessinsider.com/business-investment-sensitivity-to-interest-rates-2014-1#ixzz2qXqvjHoN

In other words, one of the goals, namely to increase investment, that the policy makers hoped to achieve through the low interest rate policy hasn't been achieved.

Private non-residential fixed investment, federal funds rate, and real interest rate

If we look at the above graph, business sector hasn't been really responding to the historically low real interest rate. It may be due to the uncertainty created by the Fed's policy tools.

Overall, total real private investment hasn't gotten back to a level it was at before the recession.

This slow increase in private investment has been one of the reasons the recovery has been slow since the recession. The Fed should increase the business and consumers confidence to increase investment.