Investor Insights The Most Important Thing

How might the labor force participation rate affect investors?
Investor Insights explores the underlying forces in the U.S. labor market and what role it may play in the remainder of the current business cycle.

When will it end? The National Bureau of Economic Research (NBER), the official arbiter of U.S. business cycles, dates the start of our current expansion to June of 2009. This makes our current expansion one of the longest in the 160-year history of the NBER’s database. We have long argued that expansions do not die of old age, but rather by running out of capacity to grow. Resultant inflation pressures trigger higher interest rates that ultimately slow the economy, ending the business cycle. With labor markets tightening and wage inflation starting to take hold, we believe that one metric, the “Labor Force Participation Rate,” will ultimately determine the duration and pace of the remainder of our expansion.

The Rise and Fall of Labor Force Participation

The Labor Force Participation Rate is a widely quoted, but often misunderstood, measure of the health of the labor markets. On the surface, it seems straightforward. The federal government’s Bureau of Labor Statistics defines this metric as, “The labor force as a percent of the civilian noninstitutional population.”

However, the calculation of labor force participation comes with some important caveats. For example, “labor force” includes those employed and the unemployed who are actively seeking work but has no qualifier for the amount of work accomplished; a 16-year old clocking one hour a week at minimum wage is counted in the labor force, the numerator of the participation formula. There is also no upper age limit on the “civilian noninstitutional population” used as a base; a happily retired 80-year old is counted in that denominator. In fact, most observers believe that roughly half the decline of labor force participation since the 2000 peak has been driven by Baby Boomers retiring faster than the Millennial generation has entered.

Whatever the drivers, understood broadly, high labor force participation and especially rising rates of labor force participation are associated with periods of robust economic growth. The rising participation rates of the ‘80s and ‘90s, a reflection of more women entering the workforce and the general entry of Baby Boomers, helped drive the rapid growth of those decades. Conversely, the declining participation since 2000 contributed to the sub-par growth rates of the current century.

What’s a Policymaker to do?

Although demographic shifts accounted for much of the decline in labor force participation, policymakers have long believed other forces can influence this important economic input. Federal Reserve chair Janet Yellen actually co-authored a piece in 1990, “Waiting to Work,” which outlined some of the dynamics. She and her collaborators pointed out that labor force participation declines as expected in a recession, it does not actually bounce back until later in the economic cycle when labor markets are tight enough to generate higher wages. Skilled labor was, in effect, not just waiting to work, but waiting for higher pay to work.

The inference of such a relationship is that policymakers could generate a win-win scenario today by allowing what Yellen termed a “high pressure” economy, where wage inflation would draw in higher worker participation. If this policy was successful, it would not only mitigate the risk of runaway inflation since the supply of workers would increase, that same boost to labor force participation would foster faster growth.

The Atlanta Fed “Wage Tracker,” suggests wage inflation has been running at the highest levels since the 2008-09 recession, yet labor force participation rates have done no better than stabilize. In other words, the traditional formula is not working. The Fed’s rate hike at their March meeting may signal the central bank’s recognition that their policy lever is not working as expected. Without the buffer of a rise in labor force participation, continued monetary stimulus risks wage-led inflation well beyond the Fed’s 2% target without an improvement in real growth.

The New Structural Challenge

We believe that the labor market structure today is different from preceding periods in three important ways, and these shifts disrupt the traditional relationship between wages and labor force participation rates.

  1. The 2008-09 recession left an unprecedented legacy of long-term unemployment. The average duration of unemployment typically peaks at 15-20 weeks in recessions. In the wake of our last downturn the average duration of unemployment peaked at over 40 weeks and remains a stubbornly high 25 weeks. The longer a worker remains unemployed the harder to become employed and the more likely to drop out of the labor force altogether.
  2. The scale of opioid addiction is an unprecedented plague on our nation and the future of our workforce. Recent academic work surveyed young men and found that of the unusually high number not in the labor force, half admitted to using pain pills. On a broader level, drug overdoses now kill more Americans than car accidents with the overdose deaths of prescription pain killers exceeding deaths from heroin and crack cocaine combined. The opioid epidemic transgresses socioeconomic borders in its reach and severity.
  3. Intertwined with addiction-related issues, rising and high incarceration rates that peaked in 2008 have resulted in millions who have the “taint” of a criminal record. The Bureau of Justice Statistics reports that the 5-year recidivism rate is 76%, reflecting a failure to reintegrate former offenders successfully in the workforce.

Social Ills are Now Economic Problems

U.S. labor markets are tight and likely to get tighter. Traditional business alternatives of relying on immigrant labor or offshoring production may be less viable given the current political backdrop. Automation and capital investment to increase productivity will offer companies important tools to work around a limited supply of labor but ultimately is only a limited remedy. The final “safety valve” of tight labor markets, the traditional increase in labor force participation rates as wages rise, is not functioning well.

The failure to reengage the long-term unemployed, the failure to prevent addiction or move addicts through recovery, the failure to rehabilitate fully those who have “paid for their crimes,” have all been thought of primarily as social ills. In our time of tight labor and limited alternatives, these social ills are now economic problems.

The Investor Perspective

While we are ever hopeful that innovative remedies will arise, investors must take into account the most likely scenario: labor force participation will not rise meaningfully in response to higher wages. This suggests that labor markets will tighten and wages will rise faster than expected. This is mixed news for investors. Bond markets fare worst in this scenario, as inflationary pressures imply a more aggressive Fed and bond yields rise in acknowledgement of inflation expectations. This limits the types of bonds that belong in portfolios. Equity investors, too, need to be more selective but have opportunities; for example, rising wages can bode well for consumer stocks and manufacturers of automation that can augment a limited labor pool. Ultimately, however, a labor force growing more slowly than the demand for workers moves the U.S. economy further and further into the expansion and toward the end of the business cycle. We are not at the end of the expansion yet, but now is the time for investors to be sure that the risks they take are compatible with their goals and tolerance.

The Most Important Thing

An increase in the labor force participation rate can extend the duration and prosperity of the current business cycle, adding to the prosperity of all Americans. To do that, the business community, our policymakers and our citizens will need to find ways to combat numerous challenges created by social problems. The most important metric for measuring success will be the labor force participation rate, but “the most important thing” is to help our fellow citizens find paths to lives of economic engagement and contribution.