Demographics, Not Economic Growth, Key In Ending Accommodative Monetary Policy

by: Jeffrey Rosen

After explicitly stating that monetary policy will remain in an accommodative mode until the unemployment rate stabilizes at 6.5%, the Federal Reserve officially made the unemployment rate the most important data point of the month.

The key to rate forecasts is how quickly the unemployment rate will snap back to this target. The Fed assumes that stronger economic growth will be the driver for lower unemployment. Updated demographics data, however, suggest there will likely be a return to a 6.5% unemployment rate by the middle of next year regardless of the performance of the economy.

Demographics therefore, and not strengthening economic conditions, could pose some challenges for the Fed in managing the market's expectations for its interest rate policy.

In a research paper published by the Federal Reserve Bank of Chicago, Aaronson and Brave (2013) estimated how much payrolls would need to increase each month in order to foster a downward-trending unemployment rate.

The common adage is that payrolls need to increase by 120,000 - 150,000 each month just to keep up with normal population growth. As the Baby Boomer generation retires and the working-age population decelerates in the next few years, the amount of jobs needed to keep up with population growth naturally shrinks.

Using the latest population estimates from the Census Bureau, Aaronson and Brave noticed that payrolls need to increase by only 80,000 over the next couple of years to lower the unemployment rate. Even more startling, by 2016 payrolls would need to increase by only 35,000 to foster an unemployment rate decline.

The change in trends is the result of decelerating population growth and a labor force participation rate that drops by roughly 0.3 percentage points per year.

These projections mean that the economy would reach full employment (4.8% - 5.2%) by 2016 if payrolls increase by roughly 195,000 jobs per month. The all-important 6.5% target could be reached by the middle of 2014, depending on the rate at which discouraged workers return to the labor force.

In a Goldman Sachs note, Jan Hatzius took umbrage with the calculations used by Aaronson and Brave and believes that payroll growth needs to average 130,000 - 140,000 to produce a downward-trending unemployment curve. That means a rate hike would occur sometime in 2015 if the economy continues on its current path.

Assuming population growth of 1% per year and a steady labor force participation rate, payrolls would need to increase by 130,000 per month to keep the unemployment rate steady. If the labor force participation recovers, as Goldman expects, then payrolls growth would need to be slightly higher to keep the unemployment rate fixed.

We have spent a fair amount of time looking over employment demographics over the last few years and our results are more in-line with those found by Aaronson and Brave.

There is no argument from Goldman that population growth is decelerating. The main difference between the estimates is that the Goldman study assumes that the labor force participation rate will return to pre-recession levels. Aging demographics, however, conflict with that assumption.

We created an estimate for an economy-adjusted labor force participation rate by regressing gender, race, and the output gap -- a measure of where the economy is positioned in the business cycle -- against 14 different age cohorts. This would give a labor force participation rate that is based on demographics and is absent of economic effects. These figures were then multiplied by their respective percentage of the total population and summed together.

The labor force participation rate, excluding economic factors, has naturally declined since 2000. The rate of decline has increased exponentially since 2011. By the end of Q1 2013, the actual labor force participation rate was only 0.4 percentage points below where we would expect the rate to be if the output gap was zero, indicating an economy near full employment.

Using the Census population and demographic projections through 2020, the labor force participation rate is expected to fall approximately 0.2 percentage points per year, regardless of economic conditions. That is in-line with the 0.3 percentage point drop per year in the labor force participation rate estimated by Aaronson and Brave.

Assuming the labor force participation rate falls by 0.2 percentage points per year, as our regression results find, only 100,000 jobs per month would be necessary to keep the unemployment rate steady.

If payrolls expand by 175,000 per month, which is what payroll growth has roughly averaged over the last 12 months without a notable improvement in the sub-par economic recovery, then the unemployment rate should drop to 6.5% by the second half of 2014.

This all means that demographics alone increase the likelihood that the accommodative monetary policy ends before typical signs of economic improvement, such as accelerated investment or strengthening consumption spending, are realized.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

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