Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / Why the Fed Watches the Labor Force Participation Rate
Transcript
- Lucas: So the core PCE deflator came in at 3.3 percent annualized for July — that's the Fed's preferred inflation gauge, and it's still well above their 2 percent target. But here's the thing that's getting less attention: the unemployment rate ticked down to 4.1 percent, and yet nonfarm payrolls actually shrank by 23,000. That's a contradiction that has the Fed scratching its head. Luna: Right, if payrolls are falling, how does unemployment drop? That usually means people are leaving the labor force entirely — and that's the participation rate story we keep circling around. Lucas: Exactly. And that's the angle I want to drill into today, because the participation rate is the piece that ties the inflation puzzle together. If people are dropping out, that tightens the labor market, which puts upward pressure on wages, which feeds into services inflation — the sticky part of the PCE index. But the participation rate has actually been creeping up, which muddies that narrative. Luna: So which is it? Are we losing workers or gaining them? Because the July jobs report seemed to show both. Lucas: That's the riddle. Let me unpack it. The participation rate is the share of the working-age population that's either employed or actively looking for work. It fell sharply during the pandemic — from around 63.3 percent in early 2020 to a low of 60.2 percent in April 2020. It's recovered since, but it's still below where demographic trends suggest it should be. And in the latest data, it's been drifting higher by a tenth or two each month. That's actually a sign of strength — more people are coming off the sidelines. Luna: But if more people are joining the labor force, that should ease wage pressure, not intensify it. So why is core PCE still running hot at 3.3 percent? Lucas: Because the participation rate isn't the only force at play. You've got the composition effect — the people coming back aren't necessarily the same as the ones who left. A lot of the new entrants are younger workers or those with less experience, and they're entering at lower wage levels. That actually drags down average hourly earnings — which we saw, it was flat at 37.60 in July. So the headline wage number looks benign, but underneath, the existing workforce is still pushing for bigger raises. Luna: Hmm, so the participation rate is kind of a double-edged sword for the Fed. It can mask wage pressures even as it adds workers. Lucas: That's the nuance. And it's why the Fed is so focused on the participation rate right now, not just the unemployment rate. The unemployment rate can look stable while the labor market is actually loosening or tightening underneath. Participation gives you a clearer read on slack. And that's crucial for their mandate — they're supposed to aim for maximum employment, and they won't know how close they are to that without knowing how many people are still on the sidelines who could come back. Luna: And that's where the policy debate gets interesting. We've got Warsh saying the Fed should be quieter, and Hammack saying 'now is the time to act' on rates. They're reading the same data differently. Lucas: Right. Warsh — the Fed chair — is worried about inflation and wants the central bank to communicate less so that markets don't overreact to every word. Hammack, on the other hand, is signaling that the data justifies a hike now. So you've got a split between the two poles of the committee. And the participation rate is right at the center of that split because it determines how much slack there is in the labor market. Luna: So if participation keeps rising, that would suggest there's still slack, and the Fed could hold off on hiking. But if it stalls, then the labor market is tight, and inflation pressure builds. That's a pretty sharp dividing line. Lucas: That's exactly the scenario. And it's one of the reasons why the Fed's favorite inflation gauge — core PCE — has been so sticky. Services inflation, which is heavily influenced by labor costs, is running at around 3.5 percent. Goods inflation has cooled, but services are stubborn. So the participation rate is like the canary in the coal mine for that whole category. Luna: Let's talk about the recent JOLTS numbers. Job openings fell to 7.36 million in June, down from 7.54 million. That suggests some cooling in labor demand. But if openings are falling, why are wages still sticky? Lucas: Good question. Openings are coming down, but they're still above pre-pandemic levels. And the quits rate — the share of workers voluntarily leaving their jobs — is still elevated. That's a sign that workers feel confident about their options, which keeps pressure on employers to retain them with higher pay. So even as demand cools, the wage floor is being pushed up by the churn in the labor market. Luna: So the participation rate isn't just a number — it's a behavioral signal. It tells you how confident people are that they'll find a job if they look. When participation rises, it's often because workers sense opportunity. Lucas: Exactly. And that's what makes the recent uptick in participation so important. If more people are entering because they see a strong job market, that's a self-reinforcing cycle — more workers, more supply, but also more demand for goods and services. It's not a simple supply-side fix. Luna: Which brings us back to the Fed's dilemma. They're trying to cool inflation without choking off this participation recovery. And the tools they have are pretty blunt. Lucas: Blunt is right. The fed funds rate is at 3.63 percent, and they've been on hold for a while. But with core PCE running at 3.3 percent, the real policy rate is barely positive. So there's pressure to hike, especially from Hammack's camp. But lifting rates too much could stall the participation gains — and that would be a policy mistake in the other direction. Luna: It's almost like they're trying to thread a needle between two impossible outcomes. And the participation rate is the thread. Lucas: That's the poetic way to put it. And it's why we're dedicating a whole episode to this one metric. So let's get into the weeds a bit. The participation rate for prime-age workers — those aged 25 to 54 — is actually above its pre-pandemic level. It's the younger and older cohorts that are still lagging. So the aggregate participation rate masks a strong core workforce and weaker outer edges. Luna: So if the Fed looks at prime-age participation, they might see a tighter labor market than the headline number suggests. That would argue for more hawkishness. Lucas: Precisely. And that's what some of the more hawkish members are pointing to. They're saying, look, the core workforce is fully employed, and the slack is among groups that are less likely to rejoin quickly — like older workers who retired early during the pandemic and haven't come back. So the effective labor supply is tighter than it appears. Luna: Let's bring in the 10-year breakeven rate. It's at 2.31 percent, down slightly from 2.33. That suggests inflation expectations are well-anchored, which is a point in favor of patience. Lucas: Right. If expectations stay anchored, the Fed can afford to be patient on rates. But patience isn't the same as inaction. And with the budget deficit at record levels, there's a risk that fiscal policy is doing the stimulative work that monetary policy is trying to counter. That's the story Stanley Druckenmiller and others are pushing — that the bond market's patience with Treasury supply will eventually run out. Luna: So the Fed is stuck between a fiscal stimulus that's adding fuel and a labor market that's sending mixed signals. And the participation rate is the key read. Lucas: It really is. And one of the concrete things listeners can take away today is this: when you see the monthly jobs report, don't just look at the headline unemployment rate. Look at the participation rate. If it's rising, that's a sign of slack being absorbed — and that's good for keeping wages in check. If it's flat or falling, that's a warning sign that the labor market is tighter than it looks, and the Fed might have to act. Luna: That's a great practical takeaway. And I want to add one more layer: the participation rate also affects GDP growth. With an aging population, the potential growth rate of the economy is lower. So even if productivity improves, we might not see the kind of growth we had in the past. Lucas: That's a crucial long-term point. Real GDP growth was just 1.5 percent annualized in Q2, down from 2.1 percent. Part of that slowdown is cyclical, but part of it is demographic. And the Fed can't fix demographics with rate cuts. Luna: So we're looking at a situation where the Fed is navigating not just a business cycle but a structural shift. That makes their job even harder. Lucas: Absolutely. And it's why the internal debate at the Fed is so intense. You've got Warsh saying 'be quiet and stick to the mandate,' and Hammack saying 'we need to act now.' They're both looking at the same participation data and drawing different conclusions. Warsh sees the anchored expectations and the gradual recovery in participation as a reason to hold steady. Hammack sees the 3.3 percent core PCE and argues that the longer we wait, the worse the cost later. Luna: Which side do you lean toward, Lucas? Lucas: Look, I'm not a voting member, but the data on participation suggests there's still room for the labor market to heal without overheating — if we're patient. The prime-age participation is strong, but the 55-plus group is still well below pre-pandemic. If those workers come back, that could ease wage pressures significantly. So I lean toward patience, but I understand the urgency. The risk is that we wait too long, and inflation becomes entrenched. Luna: So it's a bet on the participation rate rising further. And if it doesn't, then Hammack's camp looks right. Lucas: Exactly. The participation rate is the hinge point. And that's what makes this such a fascinating moment for the Fed. They're essentially waiting to see if the labor force keeps expanding. And every month's jobs report is a referendum on that bet. Luna: And of course, the Fed's communication strategy — or lack thereof — is adding to the uncertainty. Warsh wants less talk, but that could make markets more jittery, not less. Lucas: That's a real concern. Markets hate ambiguity. If the Fed goes quiet, investors will start parsing every data release for a signal, and that could amplify volatility. On the other hand, too much commentary — like we saw with some of the regional presidents — can create confusion. So it's a delicate balance. Luna: Before we wrap, I want to go back to something you said earlier about the composition effect. Can you give listeners a concrete example of how that plays out? Lucas: Sure. Imagine two workers: a 55-year-old engineer who retired early in 2020 and a 22-year-old recent grad entering the workforce for the first time. The engineer's return would add a high-skill, high-wage worker, which would actually push average earnings up. The grad's entry adds a low-wage worker, which pulls the average down. So if both join in the same month, the average wage could be flat — but the underlying pressure is very different. That's why the Fed looks at the wage distribution, not just the average. Luna: That makes a lot of sense. So the participation rate is like the tip of the iceberg — you have to look at who's coming in and why. Lucas: Exactly. And that's the kind of nuance that gets lost in the monthly headlines. The Fed is operating in a fog of data, and the participation rate is one of the clearest signals they have. But even that signal is open to interpretation. Luna: So what should we watch for in the next few months? Lucas: Three things: one, the participation rate — especially for the 55-plus group. Two, the core PCE — we need to see it trend toward 3 percent or below. And three, the Fed's communication. If they go quiet, that's a signal in itself. And with FOMC meetings coming up, every statement will be parsed for any hint of a shift. Luna: And if participation keeps rising, we might avoid another hike. But if it stalls, the odds of a move go up. Lucas: That's the summary. The participation rate isn't just a statistic — it's the heartbeat of the labor market, and right now it's telling the Fed to wait and see. Whether that patience pays off is the big question for the rest of 2026.