Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / How Falling Labor Force Participation Forces the Fed's Hand
Transcript
- Lucas: So the headline from last week's jobs report was payrolls growth of just 57,000 — well below expectations — and the unemployment rate ticking up to 4.2 percent. But there's another number in that report that I think matters more for the Fed, and it didn't get nearly as much attention. Luna: The labor force participation rate, right? I saw it dropped to the lowest level since the early 1970s, outside of the COVID shutdown. Lucas: Exactly. The participation rate fell to 62.2 percent. That's a level we haven't seen since the Nixon administration, if you exclude the pandemic. And the thing is, this isn't a one-month blip. It's been trending down for years, and the pandemic accelerated it. But the June data shows it's still falling — even as the economy is supposedly adding jobs. Luna: So fewer people are working or even looking for work. That should ease wage pressure, right? Less competition for workers? Lucas: You'd think so, but it's more complicated. The drop in participation is actually tightening the labor market in a weird way. If you have fewer people in the labor force, then even moderate payrolls growth can keep the unemployment rate low — or push it higher if job creation slows. But more importantly, the people who are dropping out tend to be older workers or those with health issues. They're not coming back. So the effective labor supply is shrinking. Luna: Which means employers have to compete harder for the remaining workers, pushing up wages. Lucas: Right. And we're seeing that. Average hourly earnings were up 4.0 percent year-over-year in June. That's still above the level the Fed considers consistent with 2 percent inflation. So the Fed is in a bind: the economy is creating fewer jobs, but wage growth is still too high. And a big reason is that the labor force is shrinking. Luna: So what's driving people out? Is it early retirement? Long COVID? People just giving up? Lucas: All of the above. The Fed's own research has pointed to a surge in early retirements since 2020 — about 2 million more retirees than you'd expect based on pre-pandemic trends. Then there's long COVID, which the Brookings Institution estimates has taken roughly 500,000 people out of the workforce. And then there's the discouraged-worker effect: people who've been looking for a job for so long that they just stop. That number has been rising, especially for workers without a college degree. Luna: And the Fed is supposed to manage the economy for maximum employment. But if people are leaving the workforce, is that really the Fed's problem? Lucas: It is, because the Fed's dual mandate includes price stability and maximum employment. If participation keeps falling, potential GDP growth slows. That means the economy can't grow as fast without generating inflation. So the Fed has to adjust its estimates of the neutral rate of interest — what's called r-star. A lower participation rate means a lower r-star, which means the Fed's current policy rate of 3.63 percent might actually be more restrictive than it looks. Luna: So the Fed might need to cut rates sooner than they thought, just to keep the economy from stalling? Lucas: That's the argument. But here's the problem: wage growth is still sticky. If they cut rates and the labor market tightens again, inflation could reignite. So they're stuck between a rock and a hard place. And I think that's why Chair Powell has been so cautious in his recent comments — he's basically saying, 'We need to see more data.' Luna: It reminds me of something you said a few episodes back: the Fed is data-dependent, but the data keeps sending mixed signals. Lucas: Yeah, and this is the ultimate mixed signal. Payrolls miss by a wide margin, but the underlying labor supply is shrinking even faster. The Fed's models probably aren't capturing the full effect of people dropping out. And if you look at the 10-year breakeven inflation rate, it's been flat around 2.23 percent — basically unchanged. The market doesn't see inflation running away, but it also doesn't see the economy weakening enough to force the Fed's hand. Luna: Speaking of the market, the S&P 500 hit another all-time high last week, up 1.8 percent in five days. The bond market seems calm. So investors are basically saying, 'We trust the Fed to figure this out.' Lucas: Right. And maybe they're right to. But the risk is that the Fed waits too long, and the participation drop becomes structural. If those 2 million extra retirees never come back, that's a permanent hit to the economy's capacity. And then the Fed would have to keep rates lower for longer just to get back to full employment — which could fuel asset bubbles or inflation down the road. Luna: Sort of feels like the Fed is trying to land a plane while the runway is shrinking. Lucas: That's exactly it. And the irony is, the participation rate is something the Fed can't directly control. They can influence demand through interest rates, but they can't make people decide to look for work. That depends on health, retirement decisions, childcare availability, and a whole bunch of structural factors. Luna: If walking through the economy with us has made something click — helped you understand this participation puzzle a little better — that's exactly the kind of thing listener support keeps going. We keep this podcast ad-free, and it's because of people who chip in at buy me a coffee dot com slash fexingo. Lucas: Yeah. No pressure at all, but if you find value in breaking down these Fed decisions week after week, a coffee's worth of support really does make a difference for us. And now, back to that runway. Luna: So let's get concrete. What specific data point should we be watching to see if the Fed is starting to worry about participation? Lucas: I'd watch the JOLTS data — the quits rate, specifically. If the quits rate stays elevated, it means workers still feel confident enough to leave their jobs for better pay. That's a sign the labor market is still tight. But if quits start falling while participation keeps dropping, that suggests the remaining workers are getting nervous — and the Fed might have more room to cut. Luna: And what about the Fed's own projections? They updated their dot plot in June, and they were still signaling maybe one rate cut this year. Lucas: Right. The median dot showed rates ending 2026 at around 3.4 percent. But that was before the June jobs report and the big drop in participation. I wouldn't be surprised if the next Summary of Economic Projections — in September — shows a lower terminal rate. But Powell will want to see at least two more months of data before he changes the narrative. Luna: So between now and September, it's all about participation, quits, and wage growth. Not just payrolls. Lucas: Exactly. Payrolls get the headlines, but the participation story is the deeper trend. And if you want to understand where the Fed is headed, that's the number to track.