Economic Monitor – Weekly Commentary
by Scott J. Brown, Ph.D.

Aging, Automation, and Other Labor Market Issues
September 1 – September 5

One of the key characteristics of the current economic expansion has been the decline in labor force participation. Some of that has been attributed to the aging of the population – baby-boomers stepping into retirement – but is that what’s really going on? The polarization of the labor market is a growing issue. Technological advances have divided the workforce into high-skill, high-wage positions and low-skill, low-wage positions. However, this polarization may simply be due to the severity of the economic downturn. And the unemployment rate? Well, it’s really not all that accurate.

Labor force participation is down by more than 3 percentage points since the recession began. That’s equivalent to about six or seven million missing workers. Some of that decline has been attributed to an aging workforce. The Federal Reserve has suggested that the aging of the population accounts for about a third of the decrease in participation. White House economists put it at about half. However, the Household Survey data show that participation for those aged 55 and over is actually a bit higher than before the recession and has been trending roughly flat. The decrease in participation has been more pronounced among younger workers, although prime-aged workers (25-54 years) have also experience a decline in participation.

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Older workers have been more likely to continue working. One theory suggests that many were looking to their homes as their main retirement vehicle. With the housing collapse, these potential retirees have presumably had to work a little longer (perhaps a lot longer) to fund their retirements.

The recession and gradual recovery has been especially hard on teenagers and young adults. These individuals are not getting the job experience that they would normally get in a strong economy, and their wages are likely to be generally lower for decades. This isn’t a problem unique to the U.S. It is a worldwide issue.

Technological advances have long played a key role in economic growth, but improvements have often met a mixed reception. For example, the Luddites, an early 19th century group of textile artisans, were known for smashing labor-saving textile machinery (the term “Luddite” now refers mockingly to individuals who shun new technologies). The rise of computer technology has generated concerns over the last several decades that many occupations would be made obsolete. However, as David Autor, an MIT economist and author of one of the more interesting papers presented at the KC-Fed’s recent Jackson Hole conference, notes, “journalists and commentators overstate the extent of machine substitution for human labor and ignore the strong complementarities.” Short-term job losses due to rising productivity have eventually been more than offset by subsequent employment gains.

The polarization of the labor force over the last couple of decades has been clear, but while technology has played a part, there have been other important factors, principally globalization and the economic downturns that followed the tech bubble and housing collapse. As the economy continues to recover and labor market slack is taken up, polarization should be less of an issue. Still, education is sure to remain the most important factor in labor market outcomes.

The more mind-bending aspects of Autor’s paper have to do with the more recent advances in technology. Throughout their development, computers have excelled at doing logical, ordered tasks. They haven’t done so well in using judgment. Autor quotes the philosopher Michael Polanyi: “we know more than we can tell.” Tacit understanding often exceeds explicit understanding, according to Autor. A doctor may study physiology and anatomy, but it is his experience that allows him to practice medicine. A driver’s manual may tell one how to drive a car, but the actual task is much more complex than following a simple set of rules. For computers this is beginning to change. Advances in artificial intelligence allow computers to learn more like a human would (and much faster). Combine that with the rapid progress in robotics, and the future looks to be a fascinating place (or at least until Skynet becomes self-aware). Jobs will be lost in this transition (cab drivers, for example), but other jobs will come along, typically things we can’t even imagine right now. In 1900, 41% of U.S. workers were employed in agriculture. By 2000, this share was 2%.

Finally, it’s common knowledge that the decline in labor force participation has biased the unemployment rate lower. However, there’s also some evidence that respondents have been more reluctant to respond correctly to government queries. Hence, the unemployment rate is even less valid. That’s why we focus on a wide range of labor market indicators.

Not Quite as Anticipated
August 25 – August 29

In her Jackson Hole speech, Fed Chair Janet Yellen presented a balanced look into the issue of labor market slack and how monetary policy should respond over time. While there is plenty of slack currently, the bigger questions are how rapidly that slack will be taken up and how the Fed should position monetary policy in response. Yellen offered no clear answers.

In past months, Yellen emphasized that the Fed is looking at a broad range of labor market indicators, not simply the unemployment rate and nonfarm payrolls. However, in her Jackson Hole speech, she noted that “estimates of slack necessitate difficult judgments about the magnitudes of the cyclical and structural influences affecting labor market variables, including labor force participation, the extent of part-time employment for economic reasons, and labor market flows, such as the pace of hires and quits.” Recent research suggests that the behavior of these and other labor market indicators have changed since Great Recession.

Yellen noted a “convenient way to summarize” the various labor market indicators. The Fed’s Labor Market Conditions Index, derived from 19 labor market indicators, “supports the conclusion that the labor market has improved significantly over the past year, but also suggests that the decline in the unemployment rate somewhat overstates the improvement in overall labor market conditions.”

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Yellen had apparently read beforehand the research papers presented at the KC-Fed’s monetary policy symposium, as she incorporated some of the key findings into her speech. Notably, the labor market is significantly less fluid, reducing employment opportunities, keeping unemployment higher, reducing productivity growth, and limiting wage growth.

Another possible explanation for the weak recovery in the labor market is the concept of polarization — growth in high-education, high-wage jobs, growth in low-education, low-wage jobs, and not much in between. One of the papers presented in Jackson Hole makes a compelling argument that this bifurcated labor market phenomenon is due less to technological change and more to globalization and the aftermath of the housing collapse. This need not be permanent, but adjustments are likely to be slow, costly, and disruptive (more on this next week).

A key issue in labor market debate is how much of the soft labor market recovery has been cyclical and how much has been structural, and whether cyclical weakness may be turning into structural weakness. Yellen noted that “despite challenges in assessing where the share of those employed part time for economic reasons may settle in the long run, the sharp run-up in involuntary part-time employment during the recession and its slow decline thereafter suggest that cyclical factors are significant.” Moreover, “the balance of evidence leads me to conclude that weak aggregate demand has contributed significantly to the depressed levels of quits and hires during the recession and in the recovery.”

“The pattern of subdued real wage gains suggests that nominal compensation could rise more quickly without exerting any meaningful upward pressure on inflation.” And, “since wage movements have historically been sensitive to tightness in the labor market, the recent behavior of both nominal and real wages point to weaker labor market conditions than would be indicated by the current unemployment rate.” However, Yellen went on to suggest three reasons to be more cautious. One is that firms may have had difficulty in cutting wages during the downturn. This “pent-up wage deflation” may be leading to more modest increases in nominal wages currently. Second, weak wage growth may reflect secular trends, such as changing patterns of production and international trade (and possible measurement issues). The third possibility is that dislocations from the Great Recession may be leading to a more permanent lower trend in wage growth, as those dropping out of the labor force may face a difficult time coming back.

Turning to monetary policy, Yellen noted that given the “substantial” degree of slack in recent years, “the need for extraordinary accommodation is unambiguous.” However, Fed policymakers are “naturally shifting to questions about the degree of remaining slack, how quickly that slack is likely to be taken up, and thereby to the question of under what conditions we should begin dialing back our extraordinary accommodation.” As Yellen noted there are dangers in raising rates too soon as well as too late. “There is no simple recipe for appropriate policy in this context.”

A Roadmap, Not a Timetable
August 18 – August 22

On Friday morning, Fed Chair Janet Yellen will deliver the keynote address at the Kansas City Fed’s annual monetary policy symposium in Jackson Hole, Wyoming. Those looking for clues on the timing of the first Fed rate hike are likely to be disappointed. As Yellen previously noted, “it depends.” Yellen’s speech should provide insight into how the Fed views the current labor market situation and, more importantly, how monetary policy will respond to changing job conditions as it begins to normalize monetary policy in the months ahead.

We can expect Yellen to address many of the key topics in the labor market and Fed policy debates. Specifically, how much slack remains in the job market? What drives compensation gains; is it overall unemployment, short-term unemployment, measures of under-employment? How much of an increase in wage inflation is the Fed willing to tolerate and for how long?

We already have some indication of how Yellen will characterize the job market. While the unemployment rate has fallen significantly from its recessionary peak, a lot of that is due to a decrease in labor force participation. Some of the decrease in participation is demographics, reflecting the aging of the population. However it’s also likely that the job market is a lot more flexible that most people think.

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The Bureau of Labor Statistics Business Employment Dynamics (BED) data don’t get much attention from the financial markets. They arrive with a lag (we currently have information up to 4Q13). The monthly employment report is by far the most significant of the monthly economic data releases. However, the monthly payroll estimate is a net figure. Millions of jobs are gained and million are lost each quarter, partly reflecting seasonality (the school year, the holiday shopping season). The BED data are gross measures. The recovery from the Great Recession can be characterized as a period of relatively low job destruction and a gradual uptrend in job creation.

Job losses were consistently higher in the previous expansion, but so was job creation. The BED data paint a remarkable picture for the late 1990s. At the time, job losses were very high, but job creation was even higher. It was a transformative time. Cell phones, the Internet, and computer networking transformed the way businesses operate. We also learned that the job market was a lot more flexible than previously believed. While some blame the Fed for inflating the tech stock bubble, monetary policy facilitated a lot of the transformation. Workers moved up, and those on the margins came in to fill the gaps. Lured by more attractive wages, retirees and stay-at-home spouses returned to the job market.

During the next decade, we saw the downside of the new technologies as firms could do more with fewer workers. The initial rebound from the 2001 recession was a “job-loss” recovery. We didn’t begin to add jobs until nearly two years after the recession had officially ended.

The Great Recession (or if you prefer, the Lesser Depression) was not your typical economic downturn. Given the collapse in the housing sector and a massive deleveraging of the financial sector, there was never going to be a quick turnaround. The low level of job turnover has been a chief characteristic of this recovery. The housing collapse had a lot to do with that. Tied to their underwater mortgages, workers are less inclined to pull up stakes and pursue employment in other parts of the country. Quit rates are trending higher, but only gradually. There’s much less job hopping than there was in previous cycles.

The low labor turnover rate is associated with the relatively weak growth in wages. Weak wage growth in turn limits the pace of growth in consumer spending (and thus, the overall economy). While income inequality has been an important topic this year, most of the focus has been on high-end salaries rather the struggles of the middle class and below. The focus is starting to change. One can easily observe the impact of the squeeze on the middle class in retail sales and housing.

What will reverse the week trend in wage growth? A tighter job market. A recent Chicago Fed letter suggests that there is a strong correlation between real wage growth and medium-term unemployment (those out of work for 5-26 weeks), as well as with marginally attached workers, particularly those working part time involuntarily for economic reasons.

The more interesting question is how long the Fed will be willing to tolerate a pickup in wage growth, but we first have to see that pickup before we worry about tighter policy.

Yellen’s speech is likely to suggest that there is still ample slack in the job market and to imply that the Fed will be in no hurry to raise short-term interest rates.

The opinions offered by Dr. Brown should be considered a part of your overall decision-making process. For more information about this report – to discuss how this outlook may affect your personal situation and/or to learn how this insight may be incorporated into your investment strategy – please contact your financial advisor or use the convenient Office Locator to find our office(s) nearest you today.

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