Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / How Falling Labor Force Participation Reshapes Fed Policy
Transcript
- Lucas: So the June jobs report landed on Thursday, and the headline number was soft — just 57,000 payrolls added. But I think the number that should really have the Fed’s attention is the labor force participation rate, which fell to 62.2 percent. That’s the lowest we’ve seen outside of the pandemic shutdowns. Luna: And it’s not just one bad month. The participation rate has been trending down for about a year now. What’s driving it this time? Lucas: Right, it’s a structural shift, not a cyclical blip. The Fed’s own Beige Book has been flagging for months that employers can’t find workers, especially in healthcare, hospitality, and construction. But the participation rate tells us the supply of workers is actually shrinking. Luna: We deliberately don't run ads on these episodes. If that kind of independence is something you value, you can support the show at buy me a coffee dot com slash fexingo. Helps us keep the conversation focused on the economics. Lucas: Exactly. So let’s dig into why the participation drop matters more than the payrolls number. The Fed has been laser-focused on inflation, but a shrinking labor force changes the inflation calculus. Luna: How so? I mean, fewer workers means less supply capacity, which is inflationary in the short run. But doesn’t it also slow wage growth eventually? Lucas: That’s the key tension. Normally, a tight labor market pushes wages up, which feeds into services inflation. But if the participation drop is driven by people retiring early or leaving due to long COVID — and data from the Census Household Pulse Survey suggests that’s a factor — then those workers aren’t coming back. The economy’s potential output is permanently lower. Luna: So the Fed has to decide whether to raise rates to cool demand or hold steady because the supply side is broken. That’s a tough call. Lucas: It is. And Chair Powell hinted at this in the June press conference. He said the Fed is watching participation closely, because if it’s structural, then the unemployment rate can’t be read the same way. The unemployment rate in June was 4.2 percent — up from 4.0 in May — but that’s partly because people left the labor force, not because they lost jobs. Luna: Right, the participation rate drop actually makes the unemployment rate look artificially low. If those dropouts were counted as unemployed, the U-6 measure would be much higher. Lucas: Exactly. The U-6, which includes discouraged workers and part-timers, ticked up to 8.3 percent in June. That’s still low historically, but the trend matters. The Fed’s dual mandate is maximum employment and price stability. If maximum employment is constrained by a shrinking workforce, then the Fed may have to accept a higher natural rate of unemployment — the so-called NAIRU. Luna: And that would change the whole policy framework. If the NAIRU is higher than pre-pandemic, then the Fed can’t run the economy as hot without triggering inflation. They might need to keep rates restrictive for longer. Lucas: That’s the camp I’m in. Look at the Atlanta Fed’s wage tracker: it’s still running at 4.5 percent year-over-year. That’s not consistent with 2 percent inflation unless productivity growth is stellar. And productivity has been decent — around 2 percent annualized last quarter — but not enough to fully offset wage gains. Luna: So the Fed is stuck. They can’t ease until they see sustained evidence that inflation is coming down, but the participation drop is a structural supply shock. Rate hikes don’t bring workers back. Lucas: Exactly. And that’s why the bond market is pricing in a prolonged hold. The ten-year Treasury yield is at 4.48 percent, and the two-year is at 4.23 percent. That’s a flat curve — not inverted, not steep. The market expects the Fed to stay put for most of 2026. Luna: But there’s another angle. Some of the participation drop might be cyclical after all. If people gave up looking because they think the job market is weak, then a rate cut could bring them back. Lucas: That’s the hopeful view. But the data doesn’t support it. The JOLTS report shows that quits are still above pre-pandemic levels, which means workers are confident they can find better jobs. The people dropping out are mostly older workers and those with health issues. That’s not coming back with lower rates. Luna: So what does this mean for the next FOMC meeting? The July meeting is in three weeks. Lucas: I think they hold again. The fed funds rate is at 3.63 percent, and they’ve been on pause since March. The consensus in the dot plot was for two cuts this year, but that was before the participation data came out. If the labor force is shrinking, they may need to revise their terminal rate higher. Luna: Terminal rate meaning the level where they stop cutting in the next cycle? Lucas: Exactly. If the neutral rate — R-star — has moved up because of structural supply constraints, then even a 3.5 percent fed funds rate might be stimulative. That would mean they can’t cut as much as they thought. Luna: It’s a paradigm shift. The Fed spent the 2010s worrying about too-low inflation and a slack labor market. Now they’re dealing with the opposite. Lucas: And the tools are different. You can’t fix a participation problem with interest rates. That requires immigration reform, childcare subsidies, health policy — things outside the Fed’s mandate. Luna: Which is why Powell keeps saying the Fed needs fiscal help. But Congress is gridlocked. Lucas: So the Fed is left managing the consequences. They’ll keep rates where they are, watch core PCE — which is at 2.6 percent year-over-year as of May — and hope that supply-side improvements happen on their own. Luna: Or that participation starts to recover. A big unknown is whether the long COVID effect fades. Some people may return to the workforce as treatments improve. Lucas: That’s a real possibility. The CDC estimates that 1 in 13 adults have long COVID symptoms. If better treatments reduce that number, we could see a meaningful boost to labor supply over the next year. Luna: And that would be a game changer for inflation, because it would increase the economy’s capacity without overheating. Lucas: Right. But in the meantime, the Fed has to base policy on the data we have, not the data we hope for. And right now, the data says the labor force is shrinking, which means the economy can grow more slowly without generating excess slack. Luna: So the risk is that they keep rates too high for too long, waiting for inflation to come down, but the inflation is partly structural. Lucas: That’s the balancing act. And it’s why the next few months are so critical. If participation stays below 62.5 percent, the Fed may have to accept that 3 percent inflation is the new normal, or risk a recession by tightening into a supply-constrained economy. Luna: It’s a good reminder that monetary policy is as much about demographics as it is about interest rates. Lucas: Exactly. And that’s the takeaway for today: the participation rate is the most important number that nobody’s talking about. It’s not as flashy as payrolls or CPI, but it tells you where the economy is headed. Luna: And we’ll be watching the July FOMC statement to see if they mention it more explicitly. Thanks for joining us on the Federal Reserve Podcast. Lucas: We’ll be back next week with more. Take care.