Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / Why the Fed Cant Ignore Falling Labor Force Participation
Transcript
- Lucas: The headline number from last Thursday's jobs report was the 57,000 payroll gain — weak, but maybe noisy with the World Cup hiring bump and all. But the number I keep coming back to is the participation rate. Luna: You mean the headline everyone glossed over? Because it's not seasonally adjusted in a way people think. Lucas: Exactly. The labor force participation rate fell to sixty-two point four percent, which is the lowest outside of the COVID lockdowns — and actually a tick below the trough we saw in 2015. That's not a cyclical blip anymore. That's a structural shift. Luna: But isn't participation mostly about demographics? Boomers are retiring in waves. That's been the story for a decade. Lucas: It is partly that. The peak of the baby boom retirement wave is still washing through. But here's the thing: prime-age participation — people twenty-five to fifty-four — also ticked down in June, by two-tenths of a point. That's not retirement. That's something else. Luna: So people in their thirties and forties are just... dropping out? That feels more like a labor market signal than a demographic inevitability. Lucas: Right. And that's why the Fed is paying close attention. If participation falls because people can't find jobs or give up looking, then the economy's potential output is shrinking. Same GDP with fewer workers means tighter capacity, which pushes up inflation pressure even with weak headline hiring. Luna: But the unemployment rate is only four point two percent. That's not screaming slack. Lucas: No, but the participation drop means the unemployment rate might be artificially low. The U-3 number only counts people actively looking. If people stop looking, they're not unemployed — they're not in the labor force at all. So the economy could have more hidden slack than the headline suggests. Luna: Or less slack, depending on why they dropped out. If it's early retirement because of pandemic wealth effects or disability, that's a permanent supply shock. Lucas: That's the billion-dollar question. The Fed's models treat participation as largely structural and slow-moving. But if it's partly cyclical — if some of those dropouts would come back if wages rose enough — then the Fed might be misreading the output gap. Luna: What's the evidence that they would come back? We saw a small rebound in 2021 and 2022 when wages were spiking, but it faded fast. Lucas: That's right. The so-called 'great reshuffling' brought some people back, but by mid-2023 participation was trending down again. Federal Reserve Bank of Atlanta research suggests that for every percentage point increase in real wages, participation might rise by only about a tenth of a point. So the elasticity is very low. Luna: Meaning the Fed can't really fix this with rate policy. They can't lower rates to coax people back into the labor force if the issue is disability, caregiving, or simply not wanting to work for prevailing wages. Lucas: Exactly. And that puts the Fed in a tough spot. If participation is structurally lower, then the economy's speed limit is lower. The Fed has to be more careful about letting the economy run hot, because you'll hit capacity constraints faster — which means inflation — without a big employment gain. Luna: So does this argue for a longer pause? The fed funds rate is at three point six three percent, and markets are pricing in a cut in September. But if the labor supply is shrinking, maybe the Fed needs to keep rates where they are to prevent overheating. Lucas: I think that's the camp the Fed is in right now. Chair Powell's language has been consistent: we need to see more evidence that inflation is sustainably moving toward two percent. A falling participation rate doesn't give them that confidence. If anything, it suggests that even modest growth could reignite price pressures. Luna: And the inflation data we do have — core PCE at three point one percent, core CPI still above three percent — doesn't exactly scream 'mission accomplished.' Lucas: No, it doesn't. The ten-year breakeven is at two point two three percent, which is above the Fed's target. Bond markets are pricing in above-target inflation for the next decade. That's partly a function of supply constraints, and labor is the biggest constraint right now. Luna: There's also the international dimension. The ECB is talking about an early exit because of French political uncertainty. If the Fed cuts while Europe tightens, the dollar weakens, which could push up import prices and inflation. So the Fed has to consider that too. Lucas: Right. So you've got a domestic labor supply problem and an external currency problem, both pointing in the same direction: be careful about easing too soon. The June jobs report, weak as it was, doesn't change that calculus because the weakness is partly a supply story, not just demand. Luna: I want to push back a little. The participation rate for prime-age women has actually risen over the past two years. So the aggregate drop is concentrated among men and older workers. That's a more nuanced picture. Lucas: That's a fair point. Prime-age women's participation hit an all-time high in May at seventy-seven point eight percent. So the decline is not uniform. But for the Fed, the aggregate is what matters for the output gap. If total labor input is shrinking, potential GDP is shrinking with it. Luna: Let's talk about the implications for the neutral rate of interest. If potential growth is lower, r-star should be lower, too. That would argue for a lower terminal rate once the cycle turns. Lucas: Theoretically, yes. But in practice, the Fed has been raising its estimate of r-star over the past two years. The latest Summary of Economic Projections had the long-run fed funds rate at two point eight percent, up from two point five percent a year ago. So they think the economy can sustain higher rates. Luna: Which contradicts the participation story, doesn't it? If the workforce is shrinking, you'd think r-star would fall. Lucas: Unless productivity is picking up enough to offset the labor decline. And we have seen some productivity gains — nonfarm business productivity grew at one point two percent in the first quarter. But that's not enough to fully compensate for a participation rate that's dropped two full percentage points since 2019. Luna: So where does that leave us? The Fed is basically flying blind on the supply side of the economy. Lucas: That's the uncomfortable truth. They have models, but those models assume a certain relationship between participation and wages that may have broken down. The pandemic changed preferences around work, around caregiving, around risk. Those changes are not fully captured in the data yet. Luna: And in the meantime, they're keeping rates steady, watching, and hoping that either participation stabilizes or productivity accelerates. Lucas: Exactly. The July FOMC meeting is coming up in three weeks. I don't expect any change in the rate, but the statement language around the labor market will be scrutinized. If they acknowledge the participation decline more explicitly, that's a signal they're worried about supply. Luna: It's a tricky balance. They don't want to talk the economy into a recession, but they also don't want to appear complacent about inflation. Lucas: Right. And I think one of the reasons we can have a conversation like this — digging into the nuance of labor force participation — is because this show doesn't have to chase clicks or fill ad breaks. We can spend time on the stuff that actually matters for understanding policy. Luna: That's part of why listeners tell us they appreciate the show. It's ad-free, and we don't have to simplify things for a commercial break. Lucas: Exactly. So if you find value in that approach, and you'd like to help us keep it that way, the simplest way is to visit buy me a coffee dot com slash fexingo. No pressure, no perks — just a way to support what we do. Luna: And it genuinely helps. Even a small contribution lets us know people are listening and care about this kind of deep dive. Lucas: Alright, back to the participation puzzle. One final data point I think is worth noting: the employment to population ratio for prime-age workers has also slipped, from eighty point nine percent in May to eighty point seven percent in June. That's not a huge move, but it's consistent with the idea that the softening is real, not just statistical noise. Luna: So the next payroll report on August seventh will be critical. If July shows another month of weak job gains and another participation dip, the narrative could shift from 'soft landing' to 'stall speed'. Lucas: Or to 'stagflation lite' — low growth, persistent inflation, and a shrinking workforce. That's the scenario the Fed fears most, because they have no good tools for it. Luna: They can't create workers. They can only create demand or destroy it. Lucas: Exactly. And that's why participation isn't just a labor market statistic. It's the key variable for the entire rate path over the next twelve months.