"The retreat from work, in short, has had a real impact." - Richard Vedder, Professor of Economics Emeritus at Ohio University
In an era of policy-driven capital markets it's essential to stay in tune with and even anticipate major policy shifts before they are yesterday's news. Some policy makers are more influential than others, and perhaps the most important global player is the U.S. Federal Reserve. The Fed is currently undertaking two extraordinary policy measures: short-term rates near zero percent and large scale asset purchases known as quantitative easing ("QE"). These measures have had an enormous impact on investor psychology and asset prices over the past several years, and any stock or bond investor who correctly anticipates when and how the Fed begins reversing these policies will be ahead of the curve.
We believe the labor force participation rate is one of the key economic data points that will have an impact on Fed policy in the coming quarters. Defined as the percentage of the U.S. population age 16 and older that are employed or actively looking for a job, this statistic essentially tells us how much of the working age population are "in the game" or at least on the bench waiting to be put in. In terms of economic influence, this measure punches above its weight in that its impact on unemployment, economic growth and by extension Fed policy is far greater than the credit it is given. Let's unpack recent trends in the participation rate, and then we'll discuss its possible impact on Fed policy.
A look at a long-term chart shows that in the four decades leading up to the turn of the century participation steadily increased from less than 60% to over 67% in April of 2000. This was driven by two factors: more women entering the workforce than ever before and the baby boomers entering their prime working years. Over the past thirteen years, however, participation has slowly declined back down to 63% at its most recent measurement. In other words, there are 4 fewer out of every 100 working age adults that are employed or looking for a job as compared to thirteen years ago.
Another way to look at this is the number of workers that are no longer contributing to economic growth. If we were to assume a constant participation rate of 67.3%, we can derive how many workers have actually "gone missing" since April 2000 by applying this rate to the working age population over this time frame. The chart below shows this number to be 9.8 million since April 2000.
So why the recent decline in participation? One popular answer, especially with the more pessimistic crowd, is that the economy is so bad that people are becoming discouraged and simply giving up on looking for a job. Fortunately there is a way to quantify this, and as it turns out this does not account for the drop in the participation rate. As the chart below shows, while discouraged workers did increase after the financial crisis, this rise has only contributed 0.18% to the decline in the participation rate over the past thirteen years.
Another potential answer, and one that does partially explain the decline, is that an increasing number of working age adults are now on government assistance, particularly social security disability benefits (recipients of disability benefits are typically not looking for work and thus are no longer considered participating). We discussed this dynamic back in March in our post Workers On Welfare. Since the peak in the participation rate thirteen years ago the number of people receiving disability benefits has grown by 4.6% annually vs. 1.1% growth for the working age population. Given the aging demographic of the U.S. we might expect a slight discrepancy here, but a growth multiple of over 4x seems to indicate there is something more going on than simple aging. Regardless of why this happening, we can derive from the numbers that this trend accounts for 2.5 million, or roughly 25%, of the 9.8 "missing workers" mentioned above.
We arrive, finally, at the single biggest reason for the decline in labor market participation: aging demographics. Since the BLS considers anyone over 16 years of age to be of working age, the denominator used in the participation rate calculation includes retirees. Given this fact, the higher the average age of the population, the lower we would naturally expect the participation rate to be. As shown in the chart below, labor market participation amongst 25-54 year-olds is roughly twice that of those 55 and older.
The impact of demographics on the participation rate is incredibly important to grasp, because it all but ensures that participation will continue to trend lower into the future. Less participation leads to a smaller labor force, which leads to a smaller headline unemployment rate (labor force is the denominator in the unemployment calculation). In a recent JP Morgan Market Bulletin Dr. David Kelly attempts to quantify the potential implications this has for the unemployment rate going forward. Using a number of assumptions, he backs into when the unemployment rate will dip below 6.5% given various average monthly job gains. His conclusions are shown in the nearby table. Keep in mind that the economy has added nearly 180,000 jobs per month on average over the past two years, and that number is closer to 210,000 over just the past six months. In comparison to the current FOMC estimate of August 2015, it's clear that the declining participation rate combined with increased hiring could drive unemployment below 6.5% much sooner than the Fed is expecting.
Bernanke and his team have identified unemployment above 6.5% and inflation below 2.5% as two justifications for their zero interest rate policy. In regards to QE, they have simply stated that they'd like to see "substantial improvement" in labor markets prior to stemming their purchases. Market participants have already begun anticipating a potential tapering in QE as early as this year, and our analysis on the participation rate suggests this could be a real possibility. Several Federal Reserve bank presidents, the likes of which include Richard Fisher of Dallas and John Williams of San Francisco, have also begun speaking out in favor of reducing asset purchases throughout the year and potentially ending them by year-end.
It's important to remember that we've examined only one of many potential inputs into the Fed's next policy decision, and there are also plenty of reasons not to expect a shift in monetary policy this year. The economic recovery is far from strong, and we believe Bernanke will be more inclined to keep stimulus in place well into the recovery than run the risk of reducing it too early. While it's key to our understanding of where policy may be headed next, at the end of the day, labor market participation is but one piece in the overall mosaic.
Disclosure: I am long ACWI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. Transparency is one of the defining characteristics of our firm. As such, it is our goal to communicate with our clients frequently and in a straightforward way about what we are doing in their portfolios and why. This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities. It represents only the opinions of Season Investments. Any views expressed are provided for informational purposes only and should not be construed as an offer, an endorsement, or inducement to invest.