The Federal Reserve has had its foot on the gas for so long that the conventional wisdom says a tap of the brakes can’t be far away. But just when and how hard the Fed should hit those brakes is still the subject of furious debate. The right answer — what’s really best for the economy — depends in large part on how much “slack” there is in the labor market, and economists readily admit that’s a hard measure to gauge.
Since the Great Recession, the labor force participation rate — the percentage of the population gainfully employed or looking for work — has dropped significantly. Part of the reason is demographic, because the baby boom generation is hitting retirement age. As a result, labor force participation started declining before the recession and is projected to continue that decline for at least another decade. Demographic changes and other similar issues not specifically related to economic conditions are referred to as “structural” effects.
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Part of the change clearly has to do with the economic cycle — “cyclical” effects. It hasn’t just been older Americans dropping out of the workforce; the percentage of men between ages 25 and 54 has fallen to multi-decade lows. The aftermath of the Great Recession saw extraordinarily high levels of long-term unemployment. Many of those who were unemployed for more than 27 months (the rough definition of “long-term” joblessness) became “discouraged” and left the labor force, which meant that they were no longer counted among the unemployed for purposes of official recordkeeping.
Economists are struggling to determine just how much of the decline in participation is structural and how much is cyclical — and it’s not a question with a clear answer. There is significant disagreement among economist about whether there is even a clear line to be drawn between cyclical and structural effects.
Now that the economy is creating hundreds of thousands of jobs per month, though, finding an answer is becoming a bit urgent because the Fed needs to try to calibrate its actions in a way that avoids two undesirable outcomes.
One is stimulating the economy past the capacity of the labor force to provide the needed workers, which would result in unacceptably high inflation. The other is hitting the brakes before the economy has reabsorbed all the workers who would like to return to the labor force. If that happens, we face the human cost of an unknown number of people left out of work as well as a hit to Gross Domestic Product, because the labor force is not being used to its full capacity.