(Reuters) — An army of U.S. labour force dropouts stands ready to get back in the game when conditions improve, implying wages, prices and interest rates will stay lower for longer.
Rather than being the result of demographics or choice, the rise in the number of people who are not actively looking for work is in substantial part the result of low demand for labour, according to a new study by David Blanchflower and Adam Posen, both of whom are former members of the Bank of England's rate-setting Monetary Policy Committee.
"A substantial portion of those American workers who became inactive should not be treated as gone forever, but should be expected to spring back into the labour market if demand rises to create jobs," Blanchflower, of Dartmouth College, and Posen, of the Peterson Institute for International Economics write.
That's demonstrated by the fact that a falling labour force participation rate has a statistically meaningful suppressing effect on wages, they argue. The data shows this effect is persistent over recent decades and increases, unsurprisingly, during and after the last recession.
Modest gains in employment, therefore, will bring moth-balled would-be workers back, which in turn will keep a firm lid on wage growth.
That means the Federal Reserve will likely keep interest rates low for longer than many anticipate.
That should be good for bonds, and the factors behind that might partly explain why bonds have done as well as they have despite the fact that the Fed is buying fewer of them.
And while one might argue that an ample supply of workers, depressed wage growth, and low interest rates will be a sweet combination for equities, much depends on your view of how effectively the Fed will react to continued low wage growth.
All of this matters a great deal because if you believe that the fall in labour force participation is due to baby boomers deciding to spend more time with their grandkids, then using monetary policy to try and counter that will only fan wage inflation.
If, as the paper implies, falling participation is in part unemployment by another name, a central bank has both more leeway to use monetary policy to stimulate employment and wage growth and more reason to do so.
Simple forward guidance
Of course, this debate is already raging. Fed chair Janet Yellen, noting the fall in participation to levels last seen in 1978, when far fewer woman were working, has said her view is that "a significant amount of the decline in participation during the recovery is due to slack, another sign that help from the Fed can still be effective."
That view is not universally held among Fed officials, but broadly all of them agree that the unemployment rate, which has dropped sharply, is by itself not a fantastic indicator of the state of the labour market.
As a result, the Fed has moved to a far more complex data set to use to help set forward guidance of when it might eventually raise interest rates.
Not only will it look at the unemployment rate, but also the change in the participation rate, job turnover, wage growth and long-term unemployment, among others.
That approach has advantages over simply setting an unemployment rate as a threshold, but like reading tea leaves makes almost any conclusion possible, both within the Fed and by those trying to second-guess it. That could make the Fed less effective, and most certainly will make financial markets more volatile, all else being equal.
Posen and Blanchflower propose that wage inflation should be used as the primary target of the employment side of the Fed's mandate. This has a lot to recommend it. Many of the other factors the Fed will already be watching, such as participation rate, under-employment and the unemployment rate, will influence wage growth, and in ways which smooth out any structural or demographic changes, or at least will until a more normal economy returns.
For investors, the key question is will the Fed act on this information?
Yellen, based on her recent remarks and history, seems onboard, if not with adopting wage inflation as a target, then certainly with regarding the army of labor force exiles as more than a lost cause.
There is considerably less agreement elsewhere in the Fed, and that brings up the very real possibility of a premature interest rate rise, as conditions in parts of the labor market improve and policy makers bet that wage growth will follow. Perhaps even more likely is premature jawboning by Fed officials about upcoming rate rises which, along with anticipated inflation, never quite arrives.