The Fed has a dual mandate to promote stable prices and maximum employment. With current inflation near the Fed’s long-run target of 2% and unemployment well above estimates of its “natural rate,” Fed chairman Ben Bernanke and NY Fed President William Dudley have understandably stressed their commitment to the second part of the mandate. Indeed, the Fed’s recent pledge to hold interest rates near zero through 2014 reflects their concern that unemployment will only decline slowly in the coming years, unlike in previous recoveries. Dudley has stressed the post-crisis decline in the labor force participation rate (LPR) in support of this view: had the LPR not, he said in March, “declined from around 66 percent in mid-2008 to under 64 percent in February, the unemployment rate would still be over 10 percent.” The implication is that the current unemployment figures present too rosy a picture of the state of the labor market. Upward pressure on the unemployment rate will emerge as the LPR returns to normal.
We think Dudley’s analysis is flawed. As the large figure above shows, today’s LPR is precisely where its post-2001 trend line suggests it should be. There has indeed been a sharp decline in the LPR since the crisis, but this has merely erased the pause over the four years prior to the crisis, which was driven by robust demand for workers during that period—illustrated in the small upper right figure on unit labor costs. But the broader picture is one of a steadily declining LPR as the population ages, illustrated in the small lower left figure.
In short, if the Fed pursues its low-rate pledge with the expectation that the LPR will naturally return to 2007 levels it is likely to underestimate inflationary pressures coming from an improving labor market. It will therefore hold rates too low for too long.