U.S. labor market slack, the unused part of economic production capacity, is an important economic indicator used by the Federal Reserve to determine forward guidance. The question is how much slack the FOMC thinks there is.
When Fed Chair Janet Yellen told Congress that she would base her Federal Reserve decisions on a broader range of labor market indicators than just unemployment, she sparked a larger conversation about labor market slack that until then had been limited to universities and a few financial journalists.
The unemployment rate and monthly job growth usually tell most of the story in the U.S. labor market. As the lackluster and uneven recovery continues, it is becoming clearer that this time is different. But with all the focus on more obscure measures like the job vacancy rate, initial jobless claims, and quit rates, a movement claiming that the job market is much tighter than is widely believed emerged. Their story highlights quit rates and prospects for the short-term unemployed, with an underlying concern about inflation (even though it is nearly non-existent).
But the labor market indeed does still have significant slack left in it, as shown by the diverging prospects of the unemployed across two dimensions: length of unemployment and education level.
The real question is not how much slack is in the labor market. Rather it is how much slack the voting members of the Federal Open Market Committee (FOMC) think there is, and how it affects their votes in this week’s meeting.
A tale of two classes
There are dozens of way to assess labor market slackness, but a few are useful from the Fed’s perspective. These are the ones that tell us the most about how the economy will grow over the next one to five years, since a lion’s share of the U.S. economy comes from consumer spending.
Since the recession ended, the job prospects of college-educated workers have improved dramatically. As companies begin hiring again these have been the most valuable workers, in part because many of them are overqualified for the jobs they accepted. But more broadly, they are a signal to employers of quality. In a tough job market, that is a tremendously useful signaling device. With unemployment of college graduates now below 4.0 percent, their wages have begun to grow again. It is no longer an employer’s market.
For those without college degrees, the recovery has not truly been a recovery. Unemployment remains at nearly 10 percent for workers without a high school diploma.
Hires: Total Nonfarm. Source: U.S. Department of Labor: Bureau of Labor Statistics
With a high supply of workers with low levels of education, wages on the bottom of the scale will remain low. There is simply much more labor available than employers are demanding. This is partly the reason that the Obama administration has pushed hard for a minimum wage increase recently.
Weak wage growth
Another crucial indicator is wage growth. It is certainly hard for an economy to grow when its consumers do not have more money to spend. There are many other theories on why wage growth is lagging including robots and corporate profits, but in the short run the biggest problems are frictions in the labor market.
Source: New York Times/ Goldman Sachs
The exact number changes based on the type of measurement, as Paul Krugman points out, but wage growth is still barely keeping up with inflation – and inflation is historically low.
Long-term unemployment
Source: 2014 Economic Report of the President
This might be the biggest weakness in the job market: once you are out of a job for six months, your employment prospects plummet. The reasons are too long to list, but the charts do not need long explanations. There is deadweight in the economy coming from a persistent and unusually large group of Americans who have been looking for a job for more than six months. As more states cut off unemployment benefits, it is becoming harder to put food on the table let alone keep their job skills fresh.
Hiring rate
One of the figures the tight labor market crowd point to is the job quitting rate, which has risen for the past two years. They are optimistic that this means the slack is disappearing. That logic seems sound enough, but it does not match the research on the subject.
University of Chicago economist Robert Shimer shows that the job finding rate is a better indicator of the health of the job market. The job finding rate now stands at 3.3 percent, well below the pre-recession level of between 3.8 and 4 percent.
The low job finding rate is likely connected to the high rate of long-term unemployment. In effect, there is a continental divide in the labor market. One side has the short-term unemployment with quick turnover back into employment. The other side has stagnated with long-term unemployed, unable to find a way out. Put together, the labor market remains depressed even despite a few bright spots.
The labor market still is not healthy, but the news is not all doom and gloom. Initial unemployment claims have returned to their pre-recession levels. The problem with the debate is that underlying the tight labor market crowd’s reasoning is that the Fed has to stop being so accommodating for a number of reasons, including impending inflation. But inflation still remains dangerously low in the U.S. at 1.1 percent, while unemployment (even the most common measure) sits well above its natural rate.
How does the FOMC feel about slackness?
When the Fed releases its FOMC statement this week, we will learn how many of them think the labor market is tightening fast enough to warrant a quicker end to QE and historically low interest rates.
Based on their reputations, identifying the hawkish FOMC members is relatively easy. Richard Fisher, President of the Dallas Fed, and Charles Plosser, President of the Philadelphia Fed, are the two strongest hawks voting in the FOMC in 2014. They have doubted quantitative easing for some time, and they will not embrace it now.
But their votes and statements will be interesting guides nonetheless. If they do not comment on labor market slack, it is unlikely that any member will push Yellen on the issue. In that case, look for the 6.5 percent unemployment threshold for keeping rates at 0 percent to become more flexible. The job finding rate, wage growth, U-6 unemployment, and consumer spending growth will all matter.
