Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / How Falling Participation Is Reshaping Fed Rate Path
Transcript
- Lucas: So the headline number everyone latched onto last week was the payrolls miss — 57,000 jobs added in June, well below the consensus around 200,000. But the real story, the one that keeps me up at night, is what happened to the labor force participation rate. Luna: Yeah, and it was a double hit. The participation rate fell to its lowest level in 50 years, outside of the Covid era. That's not just a blip. Lucas: Right. We're at about 62.4 percent now, if I'm reading the data correctly. That's down from 62.6 percent in May. It doesn't sound like much, but it translates to roughly 500,000 people leaving the labor force entirely. Luna: And the Fed sees that as a structural problem. Because if fewer people are working or looking for work, the economy's potential output shrinks, and wage pressures can build even with weak job creation. Lucas: Exactly. Chair Powell has been talking about this for over a year — the participation rate has never really recovered from the pandemic. But now it's getting worse, and that changes the calculus for rate cuts. Luna: So you're saying the Fed might hold rates higher for longer because of the participation drop, even though job growth is slowing? Lucas: That's the paradox. Look at the Fed funds rate — it's at 3.63 percent, flat since June. The market has been pricing in cuts later this year, but if participation keeps falling, the Fed worries about overheating in the parts of the economy that are still tight. Luna: And inflation isn't exactly dead. Core PCE is at 130.1, up from 129.67 in April. That's still above target. Lucas: Right. So you've got a labor market that looks soft on the surface — 57,000 jobs, unemployment at 4.2 percent — but underneath, the shrinking workforce is acting like a floor under wages. And the Fed hates that. Luna: Who are these people leaving? I mean, is it early retirement, or are people just giving up because they can't find work? Lucas: It's a mix. The headline from CNBC was 'Job seekers giving up', and that's part of it. But there's also a big wave of baby boomer retirements that started during Covid and hasn't stopped. Plus, we're seeing a rise in disability claims and people staying out for family care reasons. Luna: So the Fed is stuck between a rock and a hard place. If they cut rates to stimulate job growth, they risk reigniting inflation in a supply-constrained labor market. If they hold, they risk letting the participation rate fall further. Lucas: That's the bind. And the 10-year Treasury yield has been creeping up — it's at 4.48 percent now, up 2.4 percent in the last five days. That's the bond market saying, 'We don't see a recession coming anytime soon, but we also don't see inflation going away.' Luna: Which is a classic stagflationary signal, right? Weak growth, sticky inflation. Lucas: Not quite full stagflation — GDP is still growing at around 2 percent — but the risk is that we get a prolonged period of low growth and above-target inflation, which is the worst environment for the Fed. Luna: What about the other side? Some economists argue that labor force participation is a lagging indicator, and that as wages rise, people will come back into the market. Lucas: That's the optimistic view. And there's some truth to it — prime-age participation for workers 25 to 54 has actually recovered to pre-pandemic levels. The problem is that the drop is concentrated among older workers and the less-educated, who are harder to bring back. Luna: And if you're 62 and you left during Covid, you're probably not coming back unless there's a huge wage incentive. Lucas: Right. So the Fed has to think about this structurally. Powell mentioned in his last press conference that the participation rate is a key input for their neutral rate estimates. If the labor force is smaller, that implies a higher r-star — the neutral rate that neither stimulates nor restricts. Luna: So effectively, the Fed might have to keep rates at 3.63 percent or even higher for longer, even as the economy slows. Lucas: That's the uncomfortable conclusion. And I think the market is starting to price that in. The yield curve has been steepening — the 10-year minus 2-year spread is widening again — which usually happens when the market expects the Fed to hold steady. Luna: But isn't there a risk that if they hold too long, they choke off the recovery entirely? Lucas: There is. And that's why the July FOMC meeting is going to be fascinating. They have the option to cut, but the data just doesn't support it yet. CPI is at 334.0, up from 332.41 in April. Core CPI at 336.1, up from 335.42. Inflation is still trending up, not down. Luna: And on the other hand, if they don't cut, and the participation rate keeps falling, we could enter a negative spiral where businesses can't find workers, so they don't expand, so they don't hire, and people leave the labor force. Lucas: Exactly. That's the negative feedback loop the Fed wants to avoid. But they're constrained by their mandate — full employment and price stability. And right now, price stability is slipping away. Luna: Before we go deeper into the FOMC's options, I want to mention something. If you're finding these conversations useful — if walking through the economy with us has made something click — there's a simple way to help keep the show going. Lucas: Yeah, it's straightforward. A couple of dollars a month is genuinely what keeps these podcasts ad-free. You can go to buy me a coffee dot com slash fexingo. That's all lowercase, buy me a coffee dot com slash fexingo. Luna: Even a one-time contribution makes a real difference. We don't have corporate sponsors, so it's just listeners like you supporting the work. And we appreciate every single one. Lucas: Alright, back to the Fed. So the July meeting — what are the chances they actually move? The Fed funds futures are pricing in about a 40 percent chance of a 25 basis point cut in September, but zero chance for July. Luna: So they're on hold for now. But what about the dot plot? The last one in June showed four cuts penciled in for 2027, but that was before the participation data got worse. Lucas: Right. I suspect the dots will shift higher in September. If participation keeps dropping, the median projection for the fed funds rate could move up by 25 to 50 basis points. That would be a hawkish signal. Luna: And what does that mean for the average person? Higher borrowing costs for longer — mortgages, car loans, credit cards. Lucas: Exactly. The 30-year mortgage rate is already above 7 percent again. If the Fed stays on hold, that's not coming down anytime soon. And small-cap stocks, which are more sensitive to borrowing costs, have been underperforming. The Russell 2000 is only up 0.3 percent in the last five days, compared to the S&P's 1.2 percent. Luna: So the participation story isn't just an abstract economic concept — it has real consequences for household budgets and market performance. Lucas: And it's a slow-moving crisis. It doesn't get the headlines that a payrolls miss gets, but it's more fundamental. Because even if job creation rebounds, if the labor force is shrinking, the economy can't grow as fast without generating inflation. Luna: I want to look at one more data point. The 10-year breakeven inflation rate is at 2.23 percent, essentially flat. That suggests the bond market doesn't expect inflation to spike, but it also doesn't expect it to fall much. Lucas: Right. So the market is pricing in a sort of 'muddle through' scenario. Inflation stays around 2.2 to 2.5 percent, the Fed holds rates where they are, and the economy grows slowly. That's not terrible, but it's not great either. Luna: And it leaves the Fed with very little room to respond if something goes wrong — like a shock from energy prices or a geopolitical event. Lucas: That's the worrying part. The Strait of Hormuz situation, for example, could send oil prices spiking and push inflation higher. The Fed would then be in an even tighter bind. Luna: So to tie it all together: the participation rate is the key variable to watch. If it stabilizes or improves, the Fed has more room to cut. If it keeps falling, they're stuck. Lucas: I'd add that we should also watch the JOLTS data next week. If job openings start to fall sharply, that could be a sign that the labor market is weakening faster than expected, which might force the Fed's hand despite the participation issue. Luna: Good point. It's not just one number — it's the interplay between participation, payrolls, and inflation that will determine the path. Lucas: And for now, that path looks like a long pause. The Fed is data-dependent, and the data is sending mixed signals. The one clear signal is that fewer people are working, and that's going to shape policy for the rest of the year. Luna: Let's hope the participation trend reverses. But if history is any guide, that's a slow and uncertain process. Lucas: It is. And that's why this episode is titled 'How Falling Participation Is Reshaping the Fed Rate Path.' It's the quiet force behind the headlines.