The U.S. economy, fresh off another strong report, has created an average of 205,000 new jobs a month in 2019, far more than the roughly 100,000 needed to keep up with population growth. The official unemployment rate has fallen to 3.6%, the lowest in 50 years. Historically, such low unemployment has signaled that the economy is at full capacity, which causes wages and inflation to accelerate as employers compete for scare workers. Yet wage growth has increased modestly, to about 3% a year, and inflation is still running at 1.5%, below the Fed’s 2% target. What’s going on?
Maybe we’re looking at the wrong indicators. The unemployment rate has been a less reliable signal because of the trauma of the Great Recession. Official unemployment counts only people actively looking for work, and ignores those who have left the job market, including the millions who dropped out after the 2008 financial crisis.
The Federal Reserve needs to read the labor market correctly to determine how to achieve its dual mandate of stable prices and maximum employment. Because monetary policy operates with a lag, it is critical to know ahead of time if the labor market will approach maximum employment or if inflation will exceed the target rate. Misinterpreting the indicators can lead directly to bad policy that hurts the economy.
The unemployment rate lately has falsely signaled that maximum employment was near, even though millions more jobless people still wanted to work. In 2015 Federal Open Market Committee participants estimated that unemployment couldn’t go below 5.1% without triggering inflation. The rate is now 3.6%, which means 2.4 million more Americans have found work, yet inflation remains low.
There are additional signs of slack in the labor market. Though the participation rate has ticked up in recent years, the number of Americans of prime working age—25 to 54—who consider themselves in the labor force is 2.3 million lower than it would be if participation was as high as in 2000.
Remarkably, more than 70% of people who got jobs in April indicated the previous month that they weren’t looking for work. For two decades, through expansions and recessions, disability drove increasing numbers of prime-age workers out of the labor force. Economists feared this trend would never reverse. Yet in recent years people who previously had considered themselves disabled have been entering jobs. This is a wonderful development, but it adds to policy uncertainty.
Labor-market watchers must retool their methods of estimating slack. In the same way prices reflect supply and demand in most other markets, the rate of compensation growth is the best way to determine how near the labor market is to maximum employment. The price of labor—wages and other compensation—should rise at a rate roughly equal to productivity growth plus inflation. With productivity growth climbing to 1.5%, maximum employment and stable inflation will likely occur when wages are rising at a sustained rate of about 3.5%. Today wage growth is only around 3%, meaning there is likely still slack in the labor market: The economy hasn’t yet reached its capacity.
This wage-growth assessment omits the possibility that labor’s share of income will increase. Over the past 40 years, the share of national income accruing to workers has declined from 65% to 62%. If a tight labor market and strong economy cause this trend to reverse, that would provide room for even faster wage growth without inflation.
No one knows how many more Americans want to work. But if the job market continues to improve with only modest wage growth and below-target inflation, it can be safely assumed that maximum employment isn’t here yet and there is no present need to raise interest rates.
See Neel Kashkari’s Op-Ed in the Wall Street Journal.