The Labor Market Then and Now
While the third-quarter’s real GDP growth rate of 2.7 percent was an improvement over the second quarter’s 1.3 percent, it may turn out to be the best in a lackluster year, as most forecasters are currently predicting that growth will slow down in the fourth quarter. The labor market has been front and center in the minds of economists as they have been evaluating growth prospects. The Federal Open Market Committee (FOMC), the Fed’s monetary policymaking body, is no exception. In its most recent statement, the Committee emphasized that without substantial improvements in the labor market, the Fed will “continue its purchases of agency MBS, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.”
To get an idea of what such improvements might consist of, we compare current labor market conditions to those at the times when the FOMC started to increase the federal funds rate after the last two recessions, in the early 1990s and early 2000s. We use these points in time as a proxy for dates at which the FOMC might have thought the labor market had improved substantially. Of course, given the dual mandate, this proxy is not perfect. For example, the Committee might not have been fully satisfied with the progress in the labor market on these dates, but because inflation was picking up, it had to tighten policy. Looking back at past inflation, we feel this might have been the case in February 1994, when the FOMC first increased the federal funds rate following the 1991 recession, but it does not seem to have been the case in June 2004, when the Committee first started tightening policy following the “tech bust.” With this caveat in mind, the comparison should still be informative.
The last three recoveries have been dubbed “jobless,” as substantial increases in employment have lagged behind increases in GDP. This can be seen by looking at the path of the unemployment rate from the peak before each recession, through the trough of the recession (centered at zero in the chart below), and up to the first fed funds rate increase. In the current episode, the unemployment rate went from 5 percent to a peak of 10 percent and is now back down at 7.9 percent. If the goal was to get back to the pre-recession level of 5 percent, we would be roughly 40 percent of the way. This percentage is very close to where we were when the FOMC started tightening in the recovery in the 1990s and a lot better than in 2004, when the FOMC started tightening after the unemployment rate had only recovered 35 percent of its pre-recession level.
Does this mean the labor market is in the same or better shape than at the time tightening started in previous recoveries? No. First and foremost the current level of the unemployment rate is simply too high for comfort. Second, proximity to the pre-recession unemployment rate is a pretty uninformative metric: it tells us nothing about what the “normal” unemployment rate was at these different times, or what was happening to the labor force, or how lengthy the unemployment spells were.
To see how far the unemployment rate was from “normal” when the Fed started tightening in the previous recoveries, we look at estimates of the long-run level of natural unemployment currently estimated by Tasci and Zaman (2010) and compute the gap between it and the actual unemployment rate. The larger the gap, the further we are from a situation in which the labor market has normalized. While this gap was slightly below 1 percent in 1994 and even negative in 2004, it now stands at over 2 percent. By this measure it does seem the current situation is very different from 1994 and 2004.
The unemployment rate, which is the number of unemployed workers divided by the labor force—those with a job or actively looking for one—can be influenced by movements of people in and out of the labor force. These labor force inflows and outflows might cause the unemployment rate to be a less informative indicator of labor market health. Take the case of an unemployed job seeker who gets discouraged and stops looking for a job. When this happens, the unemployment rate mechanically goes down, but ostensibly, things did not improve. There is another measure, the employment-to-population ratio, which is immune to such movements and because of that it is preferred by some economists for evaluating the labor market.
It is apparent, from looking at this measure, why the “jobless” moniker has stuck, even though, in fairness, there was some employment recovery in 1993. What is astounding is how much the ratio fell in the most recent cycle and for how long it has been sitting between 58 and 59 percent—for over three years now. Note, however, that some of this change might not be entirely due to cyclical factors; it may have more structural sources like changes in demographics or a skills-jobs mismatch. Just how much of it should be attributed to those sources is the object of much debate in the economics profession.
Speaking of skills, the amount of time workers spend being unemployed has been shown to have a very significant effect on skill deterioration. While the fraction of long-term unemployed (those unemployed for 27 weeks or more) has increased in all of the past three recessions, right now a full 40 percent of the unemployed fall into this category. It is true that there are factors, like the differences in unemployment subsidies, that make the comparison across recoveries difficult, but the current number is much higher than the post-World-War II average for the U.S. economy of roughly 15 percent.
The labor market was hit harder in the Great Recession than in the previous two downturns. As a result, policy is much more accommodative now than it was then. In addition to a low federal funds rate, the Federal Reserve has been using other potentially simulative instruments like large-scale asset purchases and forward guidance (statements about what the FOMC might do in the future), which are themselves conditioning labor market outcomes. Despite all this, and judging by the measures discussed above, the labor market seems to be in much worse condition than it was at the time the FOMC started tightening policy during the previous two recoveries.