This is a bit of a bombshell: according to a new study by researchers at the Federal Reserve Bank of New York, the employment-to-population ratio — a widely-touted measure of purported slack in the labour market — is a misleading indicator.
The implications of such a conclusion are big for monetary policy. As the Fed winds down its quantitative easing program, the next major step is to begin hiking interest rates as the economy improves, the labour market heats up, and a combination of wage growth and consumer price inflation makes a comeback.
In December 2012, the Federal Open Market Committee — the Fed’s monetary policymaking body — said it would keep rates at zero at least until the unemployment rate hit 6.5%. In December 2013, the unemployment rate stood at 6.7%, and economists at some of the world’s biggest investment banks — including those at Deutsche Bank, Morgan Stanley, and Société Générale — believe the release of the January jobs report on Friday will reveal the 6.5% unemployment rate Fed-watchers have been eyeing for over a year.
Yet recently, as the unemployment rate has tumbled toward the 6.5% threshold, the FOMC has sought to downplay the significance of the unemployment rate for the rate-hike outlook in its communications, suggesting that it does not fully capture the slack in the labour market, given the large number of people who have dropped out of the labour force in the years since the recession.
The FOMC — along with others who share this view that the unemployment rate is misleading — points to the employment-to-population ratio, which has been little changed in the wake of the recession, as a better measure of the slack in the labour market than the headline unemployment rate.
But according to New York Fed researchers Samuel Kapon and Joseph Tracy, the unemployment-to-population ratio is actually the more misleading of the two indicators, and the labour market may be tighter than the FOMC believes.
“The E/P ratio is a misleading indicator for the degree of the labour market recovery,” say Kapon and Tracy.
The key is to adjust the measure for demographics, in order to capture a massive structural economic force that is now coming into play: the retirement of the baby boomer generation of American workers.
“The normalized, demographically adjusted E/P ratio is a useful additional gauge of labour market conditions,” write the researchers.
“Adjusting for changing demographics has an important impact on the picture that emerges about the degree of the labour market recovery. The actual E/P ratio suggests that the labour market has made relatively no progress since the end of the recession in recovering from the 4.1 percentage point decline in this measure. In contrast, the gap between the demographically adjusted E/P ratio using our normalization and the actual E/P ratio is a much smaller 0.7 percentage points.”
Simply put, the employment-to-population ratio did fall sharply and has failed to recover since the recession. However, an estimate of where the employment-to-population ratio should be based on demographic trends shows that the picture is much better than the unadjusted figure suggests.
If that is the case, the labour market may be tighter than the FOMC imagines — which means inflation and wage growth may be closer at hand than it currently forecasts — and the Committee could come under pressure to tighten monetary policy sooner than its current projections dictate.
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