Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / How Falling Participation Reshapes Fed Rate Path
Transcript
- Lucas: So the headline from the June jobs report was really two numbers side by side. Payroll growth of just 57,000, and the unemployment rate ticking up to 4.2 percent. But there's a third number buried in that release that might matter more for the Fed's next move — the labor force participation rate. Luna: Right, and that number dropped again. Outside of the pandemic period, it's the lowest it's been in fifty years. We're talking about people who've simply stopped looking for work. Lucas: Exactly. The participation rate fell to 62.2 percent in June. Compare that to the pre-pandemic peak around 63.3 percent. That's over a million people who've effectively left the labor force. And for the Fed, that changes the entire calculus. Luna: It's interesting because normally a low unemployment rate suggests a tight labor market, but if participation is dropping, that tightness might be more about people giving up than actual demand for workers. Lucas: Precisely. And you know, speaking of understanding how the economy really works — a small number of listeners support this show through buy me a coffee dot com slash fexingo. It's what keeps us ad-free and able to dig into these numbers every day. If walking through the economy with us has made something click for you, that's the way to keep it going. Luna: Yeah, it's a huge help. And it means we don't have to rush through topics like this to fit a commercial break. Lucas: So back to the participation puzzle. The Fed has a dual mandate — maximum employment and stable prices. The traditional reading is that low unemployment signals a hot economy, which could fuel inflation. But if that low unemployment is partly because people have stopped looking, the signal gets noisy. Luna: And the noise matters especially now because core PCE is still running at 2.5 percent, above the Fed's 2 percent target. They can't just ignore inflation. Lucas: Right. The latest core PCE reading was 130.1, up from 129.67 in April. So prices are still creeping higher. But the Fed funds rate is at 3.63 percent, effectively flat since June. The ten-year breakeven inflation rate is at 2.25 percent, which suggests the market expects inflation to stay above target for a while. Luna: So the Fed is caught between a labor market that looks weaker underneath and inflation that's still sticky. What does that do to the rate path? Lucas: It complicates the standard playbook. A falling participation rate means the economy's potential output is lower. So even modest payroll gains might be enough to keep the unemployment rate steady or even lower it further. But that also means the economy can't grow as fast without generating inflation. Luna: So the Fed might have to tolerate higher inflation for longer if they want to keep employment high? Or they could raise rates to fight inflation and risk pushing more people out of the labor force. Lucas: That's the trade-off. Chair Powell has been careful not to anchor to one specific data point. But the minutes from the last FOMC meeting showed more discussion about the participation rate than we've seen in years. Several members noted that if participation keeps falling, the natural rate of unemployment — the so-called NAIRU — might actually be lower than they estimated. Luna: That's a big deal. If the neutral rate drops, then the current fed funds rate of 3.63 percent might be more restrictive than it looks. The economy could be slowing faster than the headline numbers suggest. Lucas: Exactly. And you see that in the yield curve. The two-year note is yielding 3.72 percent, while the ten-year is at 4.53 percent. That's a steep curve by historical standards, but it's partly because the front end is pinned by expectations of rate cuts that haven't come. Lucas: It cuts both ways. On one hand, a shrinking workforce means less aggregate demand, which is disinflationary. That would argue for a cut. On the other hand, if the remaining workers have more pricing power, wages could push inflation higher. The evidence so far is mixed. Average hourly earnings rose 3.9 percent year-over-year in June, which is still above the level consistent with 2 percent inflation. Luna: So the Fed is stuck. They can't declare victory on inflation, but they also can't ignore the participation collapse. Lucas: Right. And this is where the Phillips Curve breaks down. The traditional relationship between unemployment and inflation has been flat for years. But a falling participation rate adds a new dimension — it's not just about the unemployment rate, but about who's in the labor force at all. Luna: I've been looking at the prime-age participation rate — workers 25 to 54. That actually ticked up slightly in June. So the overall drop is driven by younger and older workers leaving. Lucas: That's a crucial distinction. Prime-age workers are still hanging in there. The drop is concentrated among teenagers and workers over 55. For older workers, some of that is early retirement accelerated by the pandemic. For younger ones, it's more schooling or just disconnection. Either way, it's a structural shift, not cyclical. Luna: So the Fed can't just wait for participation to bounce back. They have to make policy assuming this is the new normal. Lucas: Exactly. And that means the maximum employment part of the mandate might be reached at a lower level of payroll growth than in the past. The 57,000 jobs added in June might be enough to keep the labor market from tightening further, but it's not enough to bring back the dropouts. Luna: So what's the path forward? Do they hold rates steady through the summer and hope participation stabilizes? Lucas: That seems to be the baseline. The fed funds rate at 3.63 percent is already restrictive. But with core PCE still above target, they can't ease until they see more convincing evidence that inflation is on a sustainable path down. The risk is that they wait too long and the labor market deteriorates further. Luna: There's also the global context. The ECB is hinting at early exit, and the dollar has been strong. That puts additional pressure on U.S. exporters and could feed into disinflation. Lucas: Good point. The broad trade-weighted dollar index has risen about 5 percent over the past year. That's like an automatic rate hike for the tradable sector. It's another reason the Fed can afford to be patient. Luna: So patient but vigilant. That seems to be the mantra. Lucas: It really is. And the participation rate is the wild card. If it stabilizes around 62 percent, the Fed can calibrate based on payrolls and inflation. But if it keeps falling, they'll have to rethink the entire framework. Because at some point, 'maximum employment' becomes a moving target. Luna: And that's the kind of uncertainty that markets hate. The S&P is at 7,504, basically flat on the week. The Dow is up a bit, but the Nasdaq is down. It feels like investors are waiting for clarity on the labor market. Lucas: They are. And the next clue will come from the JOLTS data later this month. If job openings start to fall sharply, that would signal that the labor market is cooling faster than the payroll numbers suggest. The Fed will be watching that closely. Luna: So to sum up: participation is falling, inflation is sticky, and the Fed is stuck between a rock and a hard place. But at least we have a framework to think about it. Lucas: Exactly. And that framework is evolving. The old models assumed a stable participation rate. Now we know that's not true. The Fed is adapting, but it's a slow process. For now, the message is: expect rates to stay where they are until the data gives a clearer signal. Luna: And in the meantime, the participation rate is the number to watch. Lucas: Absolutely. It's not as flashy as payrolls or CPI, but it might be the most important metric for understanding where this economy is headed.