Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / Why the Fed Cares About Falling Participation Rate
Transcript
- Lucas: So the June jobs report hit last week — payrolls came in at just 57,000, the unemployment rate ticked up to 4.2 percent. But the number that really jumped out at me wasn't the headline. It was the labor force participation rate falling to its lowest level in fifty years, outside of the COVID period. Luna: That's a staggering statistic. We're talking about people who have simply stopped looking for work. And that changes how the Fed reads the whole labor market. Lucas: Exactly. And look, this show is possible because we don't run ads — no sponsors, no commercial breaks. If walking through the economy with us has made something click, and you want to support that choice, the link is buy me a coffee dot com slash fexingo. Luna: It's a small way to keep this ad-free. And we appreciate it. Lucas: So back to participation. The headline payroll miss got the attention, but the participation drop tells a deeper story. Fewer people in the labor force means the unemployment rate can stay low even as job creation slows — because the denominator is shrinking. Luna: Right. The Fed looks at the employment to population ratio too, and that's been drifting lower. So the question is: are these people temporarily discouraged, or is this a structural shift? Lucas: That's the million-dollar question for Powell and the FOMC. If participation is structurally lower — say because of aging demographics, or because workers have permanently left for early retirement or disability — then the labor market is actually tighter than the unemployment rate suggests. Luna: And that would argue for higher rates for longer, because you'd have less slack to absorb demand without generating wage inflation. Lucas: Precisely. The Fed's own estimates of the natural rate of unemployment, the so-called NAIRU, depend on participation assumptions. If the participation rate has fallen by a full percentage point since 2020, the NAIRU could be a lot lower than the 4.2 percent unemployment we're seeing now. Luna: Meaning we might already be at full employment, or even beyond it. And that puts upward pressure on wages, which feeds into services inflation — the stuff the Fed cares most about. Lucas: That's the channel. And it's not just theory — look at the core PCE data we got in May. It came in at 130.1, up from 129.67 the month before. That's still above the Fed's two percent target when you annualize it. Luna: So falling participation is contributing to sticky inflation. The Fed can't ignore that. But there's another reading: maybe these workers come back if the economy strengthens or if wages rise enough. That would increase supply and ease inflation. Lucas: Right, that's the cyclical view. Some of the drop is pandemic-era early retirement that could reverse if the cost of living keeps rising. But the labor force participation rate for prime-age workers — 25 to 54 — has actually recovered more than the overall rate. The headline number is dragged down by aging boomers. Luna: That suggests the structural component is real. The Fed has to assume some of these people aren't coming back. So they can't count on a participation rebound to cool the labor market. Lucas: And that makes the Fed's job harder. Because if you look at the yield curve, the ten-year Treasury is at 4.52 percent, up 2.3 percent over the last five days. The market is pricing in that rates stay higher. Luna: Bond yields reacting to the jobs report, but also to that participation decline. The market is saying: this labor market is tighter than the headline suggests. Lucas: Exactly. And the Fed's own rate path — the effective fed funds rate is sitting at 3.63 percent, unchanged since June. The market is pricing in maybe one cut by year-end, but that's far from certain. Luna: So what does this mean for the next FOMC meeting? They meet again at the end of July. Do they signal a pause or a cut? Lucas: I think they hold steady. The data isn't weak enough to cut — payrolls of 57,000 is soft, but it's not a collapse. And inflation is still above target. But they'll have to address the participation question in the statement. The word 'strong' is probably out. Luna: They've been saying the labor market 'remains strong' for months. But if participation is falling and job creation is slowing, that characterization gets harder to defend. Lucas: Right. They might shift to something like 'labor market conditions have moderated.' That would be a meaningful signal. And it would acknowledge that the composition of the labor force is changing. Luna: There's also the international angle. Christine Lagarde last week left the door open to an early ECB exit. If the ECB cuts before the Fed, that puts pressure on the dollar and could complicate the Fed's inflation fight through import prices. Lucas: Good point. A weaker dollar makes imports more expensive, which adds to inflation. So the Fed has to consider global central bank moves. But at home, the participation rate is their own domestic puzzle. Luna: Let's talk about the discouraged worker effect specifically. The CNBC headline said 'job seekers giving up.' How do we measure that? The Bureau of Labor Statistics has a measure — U-4 includes discouraged workers. Lucas: They do. U-4 adds discouraged workers to the unemployed. The official U-3 unemployment rate is 4.2 percent. U-4 is probably higher, maybe 4.5 or 4.6 percent. But that's still low by historical standards. Luna: So even with discouraged workers counted, the slack is limited. That reinforces the tight labor market narrative. Lucas: Exactly. And that's why falling participation is such a critical variable for the Fed. It's not just a statistic — it tells you about the productive capacity of the economy. If fewer people are working or looking for work, the economy's potential growth rate is lower. Luna: And lower potential growth means the neutral rate of interest — R-star — might be higher. So the Fed's terminal rate could be higher than pre-pandemic estimates. Lucas: That's a big takeaway. The participation decline is one reason some economists think R-star has risen. If the economy can't grow as fast without generating inflation, the Fed has to keep rates higher to cool demand. Luna: So the 57,000 payrolls number was a warning, but the participation drop is the structural story. It's going to influence Fed policy for years, not just months. Lucas: I think that's right. And as we watch the July FOMC meeting, the statement language around the labor market will be the key thing to watch. If they acknowledge the participation decline explicitly, that's a signal that they're adjusting their framework. Luna: And if they don't, the market might interpret that as the Fed being behind the curve. Lucas: Exactly. Either way, the participation rate is the dog that didn't bark in the June report. And it deserves more attention.