Opting out

Walter Molano, GUEST COLUMNIST

One of the quandaries in the market is the strength of the United States (US) labour market.

While most economists and commentators heralded the decline of the unemployment rate as the tell-tale of the US economic recovery, a closer look at the numbers suggests that the employment figure may not be as healthy as initially thought.

The calculation of the unemployment rate is a bit dreary. Every month, the US Census Bureau conducts a survey for the Bureau of Labor Statistics.

The survey estimates the number of people who are economically active and those who are looking for work. It then calculates the unemployment rate by dividing the number of unemployed people, who are actively looking for work, by the size of the labour force.

However, the composition of the labour force is constantly changing. Hence, a variable that economists study is the participation rate. This is the relationship between the number of people who are employed and the rest of the population.

In order to gain more insight into what is happening to the labour picture, the participation rate is segmented by age groups and gender.

Although mundane, fundamental changes in the participation rate will have major implications for US monetary policy.

Participation rates typically decline during recessions. After prolonged periods of unsuccessfully looking for work, the unemployed become frustrated and give up. This is, indeed, what has happened in the US since 2008, with the onset of the Lehman crisis.

However, the stabilisation of the US economy, thanks to the recapitalisation of the financial system, the devaluation of the currency and the onset of the fracking revolution, did not do anything to stem the decline in the participation rate. On the contrary, the decline in the participant rate has been accelerating.

At about 63 per cent, the participation rate is the lowest in 34 years. More importantly, it explains almost the entire decline in the unemployment rate. This clarifies why, despite relatively mild job creation, the unemployment rate improved so much.

The US unemployment rate crested over 10 per cent at the peak of the crisis, settling at 7.3 per cent last month. Yet, this corresponds almost identically to the decline in the participation rate. Therefore, it raises the question about the Federal Reserve's decision to make its policy prescriptions data-dependent.

There is a large debate in economic circles about the efficacy of quantitative easing (QE).

Many economists are arguing that its effects on the economy were nil, other than fuelling an asset bubble in risky assets and across the emerging markets. They argue that it would have been better to give clear signals to the economy, as to the direction of monetary policy, by using forward guidance and basing future changes on the performance of specific economic indicators.

This is an approach that was recently embraced by the Bank of England. One of the indicators the Fed was monitoring closely was the unemployment rate, particularly since it is one of the variables that lie within its mandate.

Given the improvement in the unemployment rate, the market was expecting the Fed to shift its monetary policy and taper QE. Yet, it did not. What made the Fed change its mind?

Being in Washington, it might have anticipated the government shutdown. Some of the more recent economic indicators were also weak. However, concerns about the participation rate may have also come to the forefront.

Clearly, they highlight why the pace of economic activity has been anaemic, despite the improvement in the unemployment rate, and the low inflation rate. That leads us to ask, why are people falling out of the workforce? Is it for demographic or economic reasons?

Different answers

Many commentators argue that the reasons are purely demographic. The ageing of the baby boom is forcing many people to retire. However, the data suggests a different answer.

The participation rate among older adults is increasing. Economic privations produced by the recession, reductions in pension benefits and losses in the marketplace are forcing a lot of older people to look for work or remain in the workforce longer than they wanted to.

The real decline in the participation rate is in the younger part of the age spectrum. It seems like the young are finding it harder to obtain work, opting to continue in school or staying at home with their parents.

In other words, it looks like the reasons for the decline in the participation are more attributed to economic factors rather than to changes in demographics. This means that the recession may be worse than many of us anticipated, and that monetary accommodation may remain in place much longer.

This could be very good news for the emerging markets, which have been the main beneficiaries of the Fed's largesse. Therefore, we may need to keep a close watch to see who is opting out of the work force, and why.

Dr Walter T. Molano is a managing partner and the head of research at BCP Securities LLC. wmolano@bcpsecurities.com