How Labor Force Participation Rate Affects U.S. Unemployment

One of the main indicators affecting the Federal Reserve’s decision of whether or not to raise interest rates is the unemployment rate. With unemployment rising significantly following the global financial crisis, the Fed has been holding its benchmark interest rate close to zero. But as the unemployment rate has since declined to pre-crisis levels, the Fed is looking to tighten its rather lax monetary policy.

Yet, unemployed persons finding new jobs is not the only way in which the unemployment rate can fall; it can also fall because the unemployed are no longer looking for work and dropping out of the labor force altogether. If this is the case, then a falling unemployment rate is not necessarily an indicator of renewed economic strength, but could indicate a structural weakness within the job market.

In order to understand how the unemployment rate is affected, it is important to know how it is calculated. First, a number of definitions are in order.

The U.S. Bureau of Labor Statistics (BLS) classifies all persons over the age of 16 as “unemployed if they do not have a job, have actively looked for work in the prior 4 weeks, and are currently available for work.” The labor force is defined by the BLS as “all persons classified as employed or unemployed.” The unemployment rate is then calculated by dividing the total number of unemployed by the total labor force. (See also: How Is Unemployment Defined?).

From this we can see that there are a number of ways in which the unemployment rate could fall. First, the most obvious way is that unemployed persons find a job and become employed. Labor force participation remains the same, while the number of unemployed decreases and the number of employed increases.

The second way is that people not currently counted in the labor force become employed. It is always possible for someone not actively looking for work to accept a job offer. As this would cause an increase in the total labor force while the number of unemployed remains unaffected, the unemployment rate would fall.

Finally, the unemployment rate could fall because those who were once considered unemployed stop looking for work, and leave the labor force altogether. These people may want work and are available to work but have given up looking. As both the number of unemployed and total labor force decrease in such a situation, it may not be obvious that the unemployment rate actually goes down. But considering the most extreme example of all those currently unemployed leaving the labor force, no matter how low the total labor force falls, the unemployment rate falls to zero.

While the first two ways in which the unemployment rate could decline are positive signs of economic strength, the final way is actually more indicative of weakness. Let’s look at the U.S. situation in order to determine whether the falling unemployment rate is a sign of strength or a sign of weakness.

Ten years ago the U.S. unemployment rate was sitting at 5%. Over the next couple of years it dipped below 5%, reaching a low of 4.4%, before beginning to rise in 2008 as a result of the global financial crisis. After reaching a high of 10% in October 2009, the unemployment rate has steadily fallen and is currently sitting at 5.1%.

With the Federal Open Market Committee estimating the median value of the normal rate of unemployment at 4.9% in their September 2015 meeting, the actual unemployment rate of 5.1% is closing in on the Fed’s target of full employment. This closing in on the employment target is part of the reason for the Fed’s indications of an interest rate hike to occur sometime this year.

Yet, the above discussion on how the unemployment rate is calculated, and factors that could affect its fall, should be reason to be somewhat skeptical of the unemployment numbers. In fact, there is another trend that makes the unemployment rate numbers look a lot less rosy.

Since about the middle of the 1960s until around the year 2000, the labor force participation rate—labor force divided by the population—has risen dramatically from just under 59% to a high of 67.3%. One of the main contributors to this rise was the increasing rate at which women were joining the labor force.

But, since 2000 the rate has been trending downward. From 2004 to 2008, the downward trend did level off with the labor force participation rate hovering around 66%, but in the aftermath of the global financial crisis the downward trend sped up significantly, with the current rate sitting at 62.4%.

While many economists argue that this decrease is partly due to many of the baby boom generation starting to retire and leaving the labor force, the prime working age (25 to 54 years) labor force participation rate has also been on the decline since the year 2000 when the rate was about 84%. Following a similar trajectory as the total labor force participation rate, albeit not as steep, the prime working age labor force participation rate is currently sitting around 80.6%. Thus, retiring baby boomers cannot be the sole reason for the decline in the overall labor force participation rate.

The fact that people in their prime working age are also leaving the labor force is more of a likely indication of a weakness in the U.S. labor market. Despite the fact that a record number of employment opportunities opened up last May with 5.4 million job vacancies across the U.S., hiring remained weak. One of the best explanations is that there is a skills-to-qualifications mismatch. Thus, despite the number of people who might want a job and are available for work, if they don’t have the skills that employers are looking for, they won’t get hired. (See also: The True Unemployment Rate: U6 Vs. U3).

While it may be tempting to think that a drop in the unemployment rate is a positive sign, the very narrow definition of the officially unemployed is evidence that the interpretation of unemployment rate trends is not unambiguous. One also needs to consider the labor force participation rate. If the unemployment rate is falling because people have given up on trying to find a job rather than actually finding a job, it is hard to see how this is evidence of a strengthening economy and reason for an interest rate hike.