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.

Is There Wage Inflation? and Is That a Problem for the FED?

In the recent Wall Street Journal's daily report, Jon Hilsenrath writes about a possible wage inflation happening in the U.S. job market as discussed by Torsten Slok and Joseph Lavorgna, who are both analysts at Deutsche Bank. On one hand, Torsten Slok points out that there has been increase in hourly earnings recently. Indeed, hourly earnings of production and non-supervisory workers increased by 2.5% from a year ago.

This surge in hourly wage could make the FED worry about inflation pressure and change their timeline of raising the interest rate. However, as Mr. Lavorgna points out, this increase in hourly earning could be just a result of a decrease in average weekly hours worked as the case where,indeed, the average weekly hours  worked has dropped for last three months.

This drop in average hours worked could be a result of a bad winter we are seeing right now. But we have to be careful when reading Mr. Lavorgna's argument. We should take his argument strongly only if most workers are salaried workers since earnings for salaried workers are fairly less uncorrelated to the hours worked than earnings for hourly waged workers. That hasn't been the case recently; 59% of the total workers were paid on hourly basis in 2012. Therefore, there are factors we should be careful about on the both sides of the argument on the possible wage inflation. Once sunny days come again, we should look at the same data on hourly wage increase and change in hours worked to see whether wage is accelerating. 

Now, let's turn to the question: if wage inflation is indeed happening, does that mean there is a possible inflationary pressure coming?

The idea behind inflation driven by wage inflation is that when there is increase in aggregate demand for some reason and a following increase in demand for labor from firms, increase in wage accelerates. Facing the accelerating wage, the firms would raise their product prices.

However, this argument for wage inflation driven price inflation lacks some other factors that could make make the price inflation unnecessary. As discussed by Gregory D. Hess and Mark E. Schweitzer in their paper "Does Wage Inflation Cause Price Inflation?", the wage increase could be from increase in labor productivity. Also, the argument that the firms will raise their price to pay higher wage for workers isn't necessarily true if the firms are in competitive market and have no power over the prices. Moreover, in their paper they concluded the other way around that price inflation could drive wage inflation. Even though more study is need on the subject, the FED could be not worried about the existence of the wage inflation and the consequence of it if it exists for now.

What Does Say Say?

In Econ 101, we learned or were told something called Say's Law. What I assumed the main statement of Say's Law was that when a producer or supplier increases its production of output, demand for the good will increase no matter what. In other words, I interpreted a famous rephrase of Say's Law, "supply creates its own demand", as simply that as long as there is supply of a good, there will be demand for it. I thought of the law as a statement about only one certain good. But it turned out that not only was my short interpretation of Say's Law plain wrong, but also it assumes and claims interesting behavior regarding demand and supply in the economy. So, what does Jean-Baptiste Say say?

In 1803, he argued that a producer supplies a good to receive other goods he or she would like to consume in return. In his word :

It is worthwhile to remark that a product is no sooner created than it, from that instant, affords a market for other products to the full extent of its own value. When the producer has put the finishing hand to his product, he is most anxious to sell it immediately, lest its value should diminish in his hands. Nor is he less anxious to dispose of the money he may get for it; for the value of money is also perishable. But the only way of getting rid of money is in the purchase of some product or other. Thus the mere circumstance of creation of one product immediately opens a vent for other products. (J. B. Say, 1803: pp.138–9)

An interpretation of the above paragraph is that, in short. when one wants to consumer more goods, he or she will produce more or increase the supply of goods he or she supplies. Once the supplier get money by selling its product, he or she now has to get rid of the money because, according to Say, the value of money decreases over time. Therefore, the supplier of X increases demand for Y by supplying more of X.

According to David Glasner on his blog post on Say's Law, Walras Law tells same story as Say's Law:

Walras’s Law says that the sum of all excess demands and excess supplies, evaluated at any given price vector, must identically equal zero. The existence of a budget constraint makes this true for each individual, and so, by the laws of arithmetic, it must be true for the entire economy. Essentially, this was a formalization of the logic of Say’s Law.

In other words, according to Walras's  Law and Say's Law, there will be no shortage of demand in the economy. Therefore, the economy will not experience cyclical unemployment caused by shortage of demand. Opposing views soon came from Malthus, J. C. L. de Sismondi  and later John Maynard Keynes in his famous the General Theory. Keynes argued the assumption made by Say, which says that the supplier of good X has to spend the money received by selling good X on other goods, such as good Y and good Z. Keynes wrote that the supplier doesn't necessarily spend all of the money received as revenue; in fact, in some condition, he or she may think saving that money under a mattress is more reasonable than spending it on some other goods. Basically, Keynes claimed that supply doesn't create its own demand. Moreover, Keynes was bold enough to reverse the statement to that demand creates its own supply. 

Also, Oskar Lange deduced that Walras's Law and Say's Law can be equivalent only in a barter economy, where goods are exchanged directly for other goods. In that case, there isn't intermediary like money, which can make Say's Law not necessarily true.

One implication of Say's Law, if we assume it implicitly holds in reality, if the monetary system can be engineered in a way that it can closely imitate a barter economy, a recession caused by inadequate aggregate demand could be avoided.

Edmund Phelps on the 80's High Unemployment Problem in Europe

In 2006, Edmund S. Phelps from Columbia was awarded the Nobel Prize "for his analysis of intertemporal tradeoffs in macroeconomic policy".  Phelps works have brought micro economics analysis in incentives of employers and employees to explain macro economic phenomena, unemployment and a natural rate of unemployment.

While studying his works, I was amused by his study on the 1980's Europe. During the first half of the decade, European countries experienced increasing unemployment rate.

His interest in the 80's Europe rests on a fact that there was no evidence of unexpected disinflation or deflation while unemployment rate was rising in the Europe. Rise in unemployment rate in Europe started when the most of the world experienced recession in the early 1980's. However, the unemployment rate in the Europe prevailed at the higher rate while unemployment in the US continuously decreased following a hike during the recession.

Then Phelps tried to solve this puzzle of high unemployment rate together with not so much deflation in Europe. First, he gave an argument on why this surge in the unemployment rate couldn't be explained by some fiscal tightening in Europe if it had one. He disproves fiscal austerity explanation for the unemployment rise by two parts. First, he just looks at the budget deficits of the leading countries in the area. He found that, in fact, there wasn't an evidence of fiscal tightening on the budget balance sheet. The following table shows that the following countries were having an easier fiscal policy than they had in 1980, when the unemployment wasn't high, during the first half of the 80s.  Moreover, he temporarily borrows a Keynesian hat and tries to see what Keynesian theory would say if there was indeed a fiscal tightening, and the the unemployed surge was caused by it. If there was a fiscal tightening during this period, decrease in the government spending or increase in tax would lower nominal interest rate according to IS-LM model "assuming that the supply of money is not permitted to change course in response." However, the empirical evidence doesn't support this Keynesian argument for high unemployment rate because the nominal interest rates in leading European countries except Denmark were higher during the period than they were in 1977.

Phelps further states:

"The evidence is all the more crucial when we reflect that, whatever the
cause, the resulting contraction of employment per se would tend to
slow the growth of nominal wages, thus to reduce the inflation premium
in nominal interest rates that borrowers are willing to pay, and hence,
other things equal, to lower interest rates. The rise of the average
European nominal interest rate is thus doubly hard to square with the
Keynesian fiscal hypothesis."

He finally gives some hope for Keynesian theory by offering a counterfactual argument that if there hadn't been fiscal tightening, the nominal interest rate, output and velocity of money would have been even higher. Therefore, according to Keynesian explanation, there was indeed fiscal tightening, that in fact lowered the nominal interest rate even though the nominal interest rate increased in absolute value. Therefore, Keynesian theory has no problem of telling the story of high unemployment in Europe. However, Phelps argues that in order for this Keynesian explanation to work, there has to be another contractionary shock other than fiscal tightening that raises the nominal interest rate while it contracts employment. If, according to him, there is not such another shock, a lone fiscal tightening would only lower the nominal interest rate in absolute term, but the nominal interest rate increased. To me, the interesting part of his argument is whether there could be a such contractionary shock that raises the nominal interest rate while contracts employment.

To explain this high unemployment period, Phelps proposed broader explanation for it which says that there was a change in the natural rate of unemployment. I will write about his explanation for rise in the natural rate of unemployment in a later post. To prepare my readers for that, I will end this post by quoting the conclusion of his paper (Phelps 1986, 509):

Our vision of the persistence of unemployment in Europe posits a
considerable degree of real wage stickiness, whether loosely imple-
mented through private understandings or enforced by public provisions
for indexation. If, to take the extreme case, the real wage of an employee
is a constant and if, as a consequence, the real cost savings (also
expressed in consumer goods) to the firm of laying off an employee,
which is the true cost of using the employee in production in view of any
benefits paid to the laid off, is likewise a constant, in the sense of having
been earlier predetermined for the course of his employment, a decline
in the real marginal-revenue productivity of labor as a result of devel-
opments such as a rise of markups, a real depreciation of the currency,
a fall of the real price of capital goods output, or a contraction of the
capital stock will cause some employees to be laid off. Further, unless
the real marginal productivity schedule is restored, laid-off workers will
remain laid off for the balance of their years as employees. In this extreme
case of real wage stickiness, it is only the entrance of new workers,
insofar as they can make deals for employment at reduced real wages in
view of the reduced marginal-revenue productivity of labor, that will
erode the average value of the real wage; but this statistical adjustment
will do nothing to put laid-off workers back to work. To the extent that
customer markets inhibit the rise of new firms to absorb the young while
contracts protect existing laid-off employees from being passed over for
recall in favor of hires of cheaper workers from the outside, new entrants
will end up bearing a share of the economy's unemployment-indeed an
increasing share as new entrants accumulate and the laid-off take the
places of retiring workers.

In the expectational sense, the equilibrium unemployment rate is thus
increased, and the natural rate with it. Yet their "long-run" values need
not have increased. (Also, it is not implied that the equilibrium rate
increased as much as the actual rate.)

Deadline is here: NBA trade deadline

(This is a post I wrote on last Wednesday, a day before the NBA trade deadline.)
While trying to find what to write about on today's post, I realized I was so exhausted by today's exam questions on macro economy. Also, I have recently been writing about monetary policy pretty much, so I thought why I shouldn't write about something totally different but still related to economics.

Tomorrow, February 20th is the last day on which the National Basketball Association (NBA) teams are allowed to trade their current players. For people who follow the professional sports, this kind of trade deadline is pretty familiar. Major European professional soccer leagues and American professional sport leagues have this deadline.

For people who might not be familiar with the NBA roster system, it is like this:

New players out of college basketball or foreign countries enter the NBA draft in each summer to get selected by the NBA teams, And the team and the player signs a contract which is guaranteed at least for two years. In other words, the player is now the teams's asset. (You remember a guy named Trey Burke, right? Well, he isn't doing bad out there)  The team has full control over where the player plays until the contract expires. In other words, if the team wants to trade the player, the team can do it without an agreement from the player in general. Once any given contract between a team and a player expires, the player can sign with any team he wants (with some exceptions). A player with no current contract is called a free agent.

Right now, I am pretty sure almost all 30 managers of the NBA teams are phoning each other to offer a trade to other teams. The main reasons any given NBA team wants to use this deadline and trade players are following:

First, a team believes they are contender for the championship, therefore it tries to maximize its possibility of becoming champion by adding better players to their current roster, This decision is almost a pure basketball decision. We can see this type of trade offers from the Houston Rockets to the Boston Celtics for Rajon Rando.

Second, a non-contender team which has a very good player whose contract is expiring after this year might want to trade this player for the best possible returns if the star player is unlikely to sign again with the team. This decision is half basketball and half financial decision. Since the team wants solid players whose contracts aren't expiring in next year in return for their star player, it still considers its future basketball success. But also the team doesn't want to just let the star player go away in the summer and leave the team with nothing in return. Therefore, the team is trying to maximize the benefit from the player by trading him. This type of decision is made for economic reasons. Again, the Boston Celtics is a team that might want to trade their superstar point guard Rajon Rondo because of his expiring contract.

Third, some trades could be seen as a pure financial decision. A team with a player who has very high salary but doesn't have great value to the team might want to trade this player for some players with low salary before the deadline. By doing so, the team will have more salary space under the salary cap, which is the upper total salary limit for any team, and it will be able to sign a big contract during the summer. In other words, the team is emptying its balance sheet to have enough space to sign a big contract in the future. The team doesn't really care about its success in this season, so it is not a basketball decision in short-run. Right now, one of the hottest trade rumors has been circling the Los Angeles Lakers and Pau Gasol, whose contract says he will make $19.3 million next year compared to average NBA player salary of $3.8 million (even though that says average, that is still...)

I hope, as a basketball fan, to see one or two blockbuster trades involving a superstar or two before tomorrow trade deadline. I am sure NBA team general managers will surprise me tomorrow. The clock is ticking.

Public Perceptions of the Forward Guidance

In my recent posts (here and here), I have been writing on the FED's forwards guidance program. To me, the forward guidance program is as interesting as the FED's co-unconventional tool, the quantitative easing, is if not as effective as it is. (Actually, I am interested in writing on the QE's aggregate effect on the recovery, but it is scary stuff to touch on) The FED implements the forward guidance (or open-mouth-operation) program to inform the market on when how long the FED will pursue the low interest rate policy and by doing so, it hopes to induce greater investment and consumption from the firms and consumers through the expected low short-term interest rate.

In their recent paper on the effects of forward guidance on the public's perception, Sack et al. suggested two possible public's interpretations of the change in the FED's forward guidance program. Here, the change in the forward guidance program means an extension on the current low interest rate policy. This is exactly the case we are in right now, where the FED has created market expectation that it would raise the short term interest rate as the unemployment rate reaches 6.5%, but now it faces an apparent slight change in their forward guidance policy. According to the authors, the FED's change in the forward guidance policy can get two possible reactions from the market.

First, the market could see the delay of the increase in short-term interest rate as a bad news. In other words, the private sector could interpret the FED's move as a sign of a weak recovery because it believes that the FED extended the low interest rate policy because the economy isn't recovering as the FED presumably forecasted when it set its former policy or the date of the increase in interest rate. In other words, this change in the forward guidance can lower the private sector's confidence in the recovery.  If this is indeed the case, the extension on the low interest policy can't have a positive effect on the behavior of firms and consumers.

The second way the public may interpret the change in the forward guidance is that it could think the FED extended the low interest rate policy to "maintain a more accommodative policy position for a longer period for a given set of macroeconomic conditions."  Unlike the first case, if the public indeed sees the more period of low interest rate as the FED's more aggressive stand on the recovery, the public expect the economy to recover sooner. In that case the, the effect of the forward guidance program on the investment and consumption will be positive.

Therefore, to have a positive effect it initially hoped to have on the consumption and investment through the forward guidance program, the FED now has to tweak its forward guidance policy in a such manner that the public will see the change in the policy as a more accommodative policy rather than just a weak recovery fix.

I want to finish the post asking Ben Bernanke to summarize the points made in this post. Bernanke explained this two possible perceptions very clearly in his following statement made in 2012:

"Has the forward guidance been effective? It is certainly true that, over time, both investors and private forecasters have pushed out considerably the date at which they expect the federal funds rate to begin to rise; moreover, current policy expectations appear to align well with the FOMC's forward guidance. To be sure, the changes over time in when the private sector expects the federal funds rate to begin firming resulted in part from the same deterioration of the economic outlook that led the FOMC to introduce and then extend its forward guidance. But the private sector's revised outlook for the policy rate also appears to reflect a growing appreciation of how forceful the FOMC intends to be in supporting a sustainable recovery."

Factors That Affect Effectiveness of Forward Guidance

The "forwards guidance" has been he FED's one of the novel tools to boost the economy after the recession at the zero lower bound. Forward guidance is the FED's public statement on how it will change or unchange the federal funds rate. We can see the latest forward guidance statement from the FED's January statement:

Committee today reaffirmed its view that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. The Committee also reaffirmed its expectation that the current exceptionally low target range for the federal funds rate of 0 to 1/4 percent will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.

Essentially, what the FED tries to achieve by such statements is to guide the market expectation of the interest rate. The FED has been using forward guidance to lower the market expectation of interest rate during the period it stated.

I should explain two types of forward guidance as introduced by Campbell et al. (2012). Odyssean type of forward guidance is when the FED commits to low interest rate policy even after the economic condition raises the natural interest rate above zero, and Delphic forward guidance is when the FED publicly forecasts its monetary policy's shape regarding the future shocks in the economy. We can see that the FED has been pursuing the Odyssean forward guidance since September 2012 because it publicly stated then that the the low interest rate policy would stay even after the economy strengthens:

To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens. In particular, the Committee also decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.

Having talked the basics of the forward guidance, we should study further what factors play a role in effective forward guidance program. First, the FED's credibility decides whether the forward guidance will achieve its goal of lowering the market expectation of interest rate.If the market doesn't believe in the FED's plan for the future interest rate, the forward guidance cannot stimulate the economy as the FED hopes. After all, what the forward guidance's mechanism bases on is the FED's policymakers' hope that the market will take the FED's statement on the future of the monetary policy as granted. Reports are coming in saying that the FED has lost its credibility since the FED is no way raising the federal funds rate even though the unemployment rate is very likely to reach 6.5% very soon. I can understand why this might distort the FED's credibility. If we look at the FED's October meeting's press statement, following statement follows the same statement in the January statement above. October's statement reads:

 ...In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.

But in December, the FED added one more statement following the above statement. The added statement follows:

...The Committee now anticipates, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal.

From this change in the forward guidance, one can say that the FED didn't follow what it forward guided previously. But to me, I don't see any credibility problem for the FED. Didn't the FED literally say in the above statement that it will more likely to extend the low interest rate even past the time unemployment rate drops below 6.5%? Didn't the FED have to modify its stand on its future interest rate policy according to the economics condition? Therefore, seeing the FED as not committing to its forward guided policy is like saying the FED has one chance to state what the interest rate will be in the next few years, and if it doesn't follow that, we cannot believe in the FED.

Rather, I think the FED faces credibility problem when it suddenly increases the interest rate when the unemployment rate lowers to 6.5% because current forward guidance tells us that the FED will very likely be pursuing near zero interest rate even after the unemployment rate hits the threshold.

Second factor that determines the effectiveness of the forward guidance is the public's forecast of the recovery. If the public believes that the economy will soon recover, then the public naturally expects a higher interest rate in the future. In that case, when the FED successfully forward guides its low interest rate policy, the consumption and investment will increase because the FED has just lowered the public's interest rate expectation. Hence, the firms and households are more likely to consume and invest more. On the other hand, if the public expects the economy to be still recovering from the recession in the future, it expects the interest rate to be lower as it is now. In that case, even the FED forward guides the economy by promising the persistence of low interest rate, the public's decision on consumption and investment isn't affected that much since its interest rate expectation isn't changed.

The working paper by Gavin et al.(December 2013) concludes following:

The stronger the expected recovery, the more households believe the future nominal interest rate will rise and the larger the stimulative effect of forward guidance on current consumption. We find that news of a −50 basis point shock to the nominal interest rate next period leads to an increase in current consumption of about 0.20 percent.

In summing up the discussion, I believe the FED's current forward guidance policy's stimulative effect is still ambiguous considering the FED's mixed signals on the economic outlook through its bond buying program tapering, which gives the market positive sign, and its reluctance to increase the interest rate even though the unemployment rate is almost at the threshold, which might worry the market. Interesting news to follow in next few months will be the FED's next change in its forward guidance program.

PS. Should the FED and Mrs. Yellen not-forward guide the public as the Chicago Bulls and Derrick Rose do?