Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / How the Fed Reads the Falling Participation Rate
Transcript
- Lucas: Luna, the latest headline from CNBC this week says the labor force participation rate has fallen to its lowest level in fifty years — outside of the Covid era. That's a huge deal for the Fed, and I think it's worth unpacking why. Luna: Yeah, I saw that. The participation rate has been drifting lower for a while, but now we're at levels we haven't seen since the 1970s. How does the Fed even interpret that? Lucas: So, here's the thing. The Fed's dual mandate is maximum employment and stable prices. But 'maximum employment' isn't a fixed number — it's the highest level of employment that's sustainable without triggering inflation. And participation is the key piece of that puzzle. If people are leaving the labor force, the pool of available workers shrinks, which can push wages up and feed into inflation. Luna: Right, so a falling participation rate could actually make the Fed more cautious about cutting rates, even if headline payrolls are weak. Lucas: Exactly. And that's the tricky part right now. We just had a payrolls print of just 57,000 for June — well below expectations. But the unemployment rate ticked down to 4.2 percent. That tells you the labor market is still tight, even though job creation is slowing. Luna: So the participation drop is sort of masking the true tightness. If more people were looking for work, the unemployment rate might be higher. Lucas: That's a really good way to put it. And the Fed has to look through these conflicting signals. On one hand, inflation has been sticky — core PCE is still above 2.5 percent. On the other hand, the economy is clearly cooling. But a falling participation rate tilts the balance toward worrying about wage-driven inflation. Luna: Speaking of which, if this show helps you make sense of these kinds of dynamics, we want to keep it free and ad-free. The way we do that is listener support — buy me a coffee dot com slash fexingo. It's a simple way to say this is valuable. Lucas: Yeah, and we really appreciate it. It keeps us independent and focused on what matters. Okay, back to the participation rate — the other angle here is what it means for the Fed's rate path. Luna: Because if participation keeps falling, the Fed might have to keep rates higher for longer to cool wage growth, even if the economy slows. Lucas: Exactly. And the market is starting to price that in. The ten-year breakeven inflation rate has dipped to 2.23 percent — down from 2.25 a few days ago. That suggests inflation expectations are moderating, but the Fed is focused on actual inflation data, not just expectations. Luna: And real rates — the ten-year Treasury yield is at 4.57 percent, so real rates are around 2.3 percent. That's pretty restrictive. Lucas: It is. And the Fed's own rate is at 3.63 percent on the effective fed funds rate. So real fed funds is about 1.4 percent — still positive but not as restrictive as the long end. That's a weird inversion. Luna: So the Fed is in a bind. They want to ease if the economy weakens, but the participation drop argues against ease. Lucas: Right, and that's why I think the next FOMC meeting will be a real debate. The data since the last meeting has been mixed — soft payrolls, sticky core inflation, and a falling participation rate. The hawks will point to the participation rate and say, 'We can't cut yet, the labor market is still tight.' The doves will say, 'But the economy is losing momentum.' Luna: And the participation rate is also a structural issue, right? It's not just cyclical. Baby boomers retiring, some people permanently dropping out — that's not going to reverse even if the economy improves. Lucas: Exactly. That's the key point. The Fed has to distinguish between cyclical and structural. If the participation decline is mostly structural — people retiring, disability, early retirement — then the Fed can't expect it to come back. That means the 'maximum employment' level is lower than it used to be, and the Fed might have to accept a higher natural rate of unemployment. Luna: Which would change their whole framework. They've been using the participation rate as a signal of slack, but if it's structural, it's not slack — it's just a smaller labor force. Lucas: Bingo. And that's why I think the Fed is increasingly looking at real rates and core PCE rather than the participation rate itself. The participation rate is now so low that it's more of a constraint than a signal. Luna: So what would change their mind? If participation starts to rise again, that would be a clear signal of slack coming back. Lucas: Right, but I don't see that happening soon. The June payrolls report also showed that the labor force actually shrunk by around 100,000 people. That's not just retirees — some people are giving up looking for work. Luna: And there's a headline about that — 'Job seekers giving up: labor force participation rate falls to lowest in 50 years.' So it's a real phenomenon. Lucas: Yeah. And the Fed is aware of it. Chair Powell has mentioned in past press conferences that they monitor participation closely. But I think the real question is whether the Fed will acknowledge that the participation decline is structural and adjust their estimates of the natural rate of unemployment upward. Luna: That would be a big shift. Because then a 4.2 percent unemployment rate might actually be below the natural rate, which would be inflationary. Lucas: Exactly. And if that's the case, the Fed may need to keep rates restrictive for longer to cool the labor market and bring inflation down to 2 percent. But the market is currently pricing in rate cuts later this year — the fed funds futures show about 50 basis points of cuts by December. Luna: So there's a disconnect between market expectations and what the participation data might imply. Lucas: Probably. But the Fed has been data dependent, and the next data points — CPI for June, which comes out next week, and the next payrolls — will be crucial. If inflation stays sticky, the hawks will have the upper hand. Luna: And if participation continues to fall, that just reinforces their argument. Lucas: Right. So the bottom line is: the falling participation rate is making the Fed's job harder. It's not a straightforward signal. It's a constraint that argues for caution on rate cuts, even as the economy slows. Luna: I think that's a really important takeaway for listeners. The Fed isn't just looking at one number — they're weighing these cross-currents. Lucas: And that's what makes this moment so interesting. The participation rate is at a fifty-year low, inflation is still above target, and the economy is cooling. The Fed has to navigate all three. It's not a simple playbook. Luna: Thanks for walking through that, Lucas. I feel like I have a much clearer picture now. Lucas: Glad to help. We'll keep watching the data and bring you the analysis as it develops.