Asset management

17 February 2014

Economist Insights Taking apart
The US unemployment rate has dropped significantly since its peak in 2009 but this is mostly due to a sharp drop in the participation rate (the proportion of working age people who either have a job or are looking for a job). Is this being driven by structural or cyclical factors? This is the question the Fed needs to answer to set its monetary policy at the right level. Joshua McCallum Senior Fixed Income Economist UBS Global Asset Management

Gianluca Moretti Fixed Income Economist UBS Global Asset Management

A common question asked in philosophy is: if a tree falls in the woods, but there is nobody there to hear it, does it make a sound? The comparable question at the moment for economics is: if a person is unemployed, but is not looking for work, are they really unemployed? This may sound somewhat arcane, but in the US at least the answer to this question is likely to affect mortgage rates, inflation and the value of everyone’s portfolio. The Federal Reserve (Fed) is mandated to target full employment and low inflation. When has the Fed achieved full employment? Is it when everyone of working age has a job? Clearly not – some of those people are not looking for work because they want to study, look after children, retire, live off someone else’s income, or they may be unable to work. It is not the Fed’s job to make these people work, so the definition is important for determining whether the Fed needs to tighten or loosen monetary policy to meet its employment objective. What about the inflation objective? Sustained inflation will only happen when wages are rising, but wages are determined by the number of people looking for jobs relative to the number of jobs available. When workers ask for a wage increase, employers will refuse if there is a long queue of people outside looking for a job. But should the employer consider only those who are waiting outside, or also those who might be tempted to apply if the wage was only a little bit higher? The Fed needs to figure out how much influence these ‘semi-unemployed’ people will have on wage negotiations, and hence on inflation. The question is particularly important because of the sharp drop since 2008 in the participation rate, the proportion of the working age population who either have a job or are looking for a job. The way we calculate the unemployment rate means that the rate can fall either because more people have jobs or because the participation rate has fallen as more people have stopped looking for a job. Almost all of the improvement in the US unemployment rate since its peak in 2009 is because the participation rate fell.

The drop in participation might be cyclical, because workers became discouraged but may start looking when the economy improves, or it may be structural which means that it will not come back. If cyclical, the Fed should be cautious in tightening because the unemployment rate will stop falling so quickly. If structural, the Fed will need to tighten quickly. There is some evidence that the behaviour of the participation rate is structural, but this varies a lot with age groups. The youngest (in the age group 16-24) are most likely to stop looking for jobs when job prospects are bad. This is not primarily because they have the option of living at home with their parents (although that does happen), but because many choose to stay in school or study instead. What is clear is that participation tends to fall when employment growth is weak, and tends to rise when employment growth is strong (chart 1).
Chart 1: The stay at home cycle Change in the employment to participation ratio (among men 16-24) and change in the employment to population ratio (12m change) 2.0 1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5 -2.0 -2.5 -3.0 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Employment-Population ratio Men 16-24
Source: Bureau of Labor Statistics, UBS Global Asset Management Note: This chart shows males only because the structural increases in female participation in the 1980s and 1970s make it harder to identify cyclical changes. In recent decades there is a high correlation between male and female participation by age cohort.

Choosing study over job searching is less common amongst older workers, but their participation rate is still quite cyclical, suggesting that many do simply become discouraged. In contrast, the oldest cohorts (above 55 years) are pretty much immune to the economic cycle. Their biggest decision about participation tends to be retirement, which is usually a permanent decision. Unfortunately, and unfairly, it is also quite likely that when an older worker loses their job in a downturn they may find it harder to find a new job so they are forced into retirement. Of the structural factors that affect overall participation, the most important is likely to be demographics. The young have quite low participation (59.2% before the crisis) thanks to the option of education (or freeloading on parents), but participation rises very quickly for those aged 25-44 (83.5%) before dropping as people enter the pre- and post-retirement cohort of over 55 (38.9%). In this sense, the US population is ageing quite quickly as the baby boomer generation reaches retirement age. Regardless of what the economic cycle is doing to the participation rate of a given age cohort, as people age they move into cohorts that have a lower participation and this pushes down the overall participation rate. There may also be non-demographic structural factors at play, for good or ill. As medical advances over the last 50 years made the older age cohort more fit and able, they became more likely to look for work. In theory people with lots of debt should be more willing to keep looking for work because they will need to meet their debt payments. Alternatively, more generous benefits systems may encourage people not to bother looking. Married or cohabiting couples may both look for work when neither has a job but once one has a job, the other may stop. There are so many possible non-demographic factors that it is almost impossible to disentangle them. Taking participation apart Nonetheless, if we can estimate the cyclical and demographic components, these factors are the residual that cannot be explained. A model that fits the participation rate of each cohort to the employment rate helps to identify the cyclical factor. The demographic factor is quite easy to figure out since everyone ages at the same rate. Using this model to decompose the cyclical and demographic effects since late 2007, before the recession began, reveals some interesting patterns (chart 2). The cyclical part of the participation cycle, which assumes that the distribution of age is unchanged, was actually quite small and has already almost reversed. If employment grows at a relatively optimistic, but not unprecedented, 2% per year over the next 3 years, then participation rates within the age cohorts would have recovered to their previous levels.

Once we take into account that people have been ageing and moving into age cohorts with lower participation rates, then we see that the participation rate should indeed have fallen to around 64%. Looking ahead, ageing would almost completely offset the benefits of faster employment growth on participation.
Chart 2: De-parting Labour force participation rate (%) with change decomposed since December 2007, including scenario of 2% employment growth until 2016 68 67 66 65 64 63 62 1998 2000 Actual 2002 2004 2006 Cyclical 2008 2010 2012 2014 Cyclical & demographic 2016

Source: BLS, UBS Global Asset Management

But the current participation rate is almost a full percentage point lower than the level forecast by the model. One explanation is that this represents the various other structural factors. Another explanation is that this represents unusual cyclical factors, because the severity and length of this recession resulted in a more severe cyclical impact on participation. This is crucial for the Fed. If the change is cyclical and starts to reverse, then even 2% employment growth could be almost completely offset by higher participation and unemployment would move sideways. If it is not cyclical then that kind of employment growth would rapidly send the unemployment rate down to levels that would quickly generate wage pressures, necessitating monetary tightening. So overall about two thirds of the drop in the participation rate can be explained by the economic cycle and demographics, but the rest remains a mystery. Until the Fed decides what explains that last percentage point, it is going to be hard pressed to set monetary policy at the right level.

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