U.S. labor market slack and the path to full employment

After years of economic tumult during the Great Recession and extraordinary actions by the Federal Reserve to jumpstart and sustain economic growth, many economists and policymakers are now calling for a return to normal monetary policy. The federal funds rate has been at zero for over 6 years now. With the economic recovery moving along, the Federal Open Markets Committee seems ready to raise the federal funds rate off zero, which the financial markets expect to happen this year.

But the question, as it has been for over a year now, is how much has the labor market actually recovered from the Great Recession. A premature rise in interest rates could arrest the labor market recovery we’re already seeing. The unemployment rate has been falling since March 2010, but it almost certainly underestimates the amount of slack in the labor market.

A new paper by Dartmouth College professor David Blanchflower and International Monetary Fund adviser Andrew Levin tried to estimate the level of labor market slack. The paper, written for the Full Employment project of the Center on Budget and Policy Priorities, looks at measures of slack by breaking them down into three different gaps: the unemployment gap, the labor force participation gap, and the underemployment gap.

The unemployment gap is the difference between the current unemployment rate and estimates of the unemployment rate when the economy hits equilibrium. The participation gap is the difference between the current labor force participation rate and the rate that would have occurred if long-run trends such as the aging of the Baby Boomers continued without the Great Recession having occurred. And finally, the underemployment gap is the percentage of the workforce that is working part-time but would like to work full time.

When it comes to all three gaps, Blanchflower and Levin find evidence of remaining slack. First, they figure that estimates of the long-run unemployment rate will continue to drop, meaning that there’s more space for the unemployment rate to drop before the U.S. economy hits full employment. Second, they believe the labor force participation rate has room to increase even as these demographic changes continue to affect the labor market. And third, the two authors expect a considerable amount of workers to still want to move to full-time employment from part-time jobs.

Furthermore, the still weak amount of wage growth is a good sign that all of these figures can go lower before wage growth really picks up, the authors conclude, meaning the labor market has more healing left to do, according to their analysis of previous data.

Yet Federal Reserve Chair Janet Yellen says that stronger nominal wage growth (before factoring inflation into the mix) is not a prerequisite for interest rate increases. Wage growth could continue to be flat and the Fed may still go head and raise interest rates. What would be the cost if wage growth stalls out? There would be many, but one consequence given recent debates might be a smaller share of income going to labor.

Given the Fed’s long-run inflation target of 2 percent and a long-run estimate of labor productivity of about 1.5 percent, nominal wage growth has to be at least 3.5 percent to keep the shares of income going to labor and capital constant. So wage growth that’s stuck below that level, say at about 2 percent, would result in the continuing redistribution from labor to capital over the past three decades.

Of course, an interest rate hike this year is not set in stone. And wage growth may soon start to accelerate. Or the Fed might raise rates only a small bit before waiting for more increases. Regardless, it’s vital to keep the costs of premature tightening in mind as the rest of the recovery plays out.