A Key Tenet of Janet Yellen's 'Lowflation' Call Might Be Off the Mark

What if the U.S. labor influx never arrives?

Is Fed Distorting Events in the Markets?

One of Janet Yellen's big reasons for thinking inflation will stay subdued may be built on a shaky foundation.

During her latest speech, the Fed chair indicated that "attracting discouraged workers back into the labor force may require a period of especially plentiful employment opportunities and strong hiring."

In other words, a prolonged stretch of robust job growth will encourage people who aren't in the workforce to begin searching for employment, motivated by the notion that gainful employment won't be too difficult to secure. This growth in labor supply would help keep wage growth, and in turn inflationary pressures, from getting out of hand.

But is there good reason to think that's how the scenario will unfold? And what if this prophesied influx never arrives?

In a recent research note, JPMorgan Senior Economist Robert Mellman noted that the labor force participation rate — the share of adults who have a job or are looking for one — has dropped to its lowest level since the 1970s even as the unemployment rate continues to decline:

Bloomberg

"[W]hile it might seem logical to expect increased labor market entry during an expansion as the jobless rate declines and the job search gets easier, this has not been the case," he wrote. "There was no such late-cycle increase in labor force entry in either of the previous two expansions, even though unemployment got down to 4.5 percent last expansion and below 4 percent in the 1990s expansion."

As such, Yellen's view assumes that things are different this time. And well they might be — the American economy did, after all, endure its worst downturn since the Great Depression and recoveries from financial crises are notoriously slow.

But Mellman also observes that as the economic recovery has gained traction, the share of the population that isn't in the labor force but decides to enter it — which typically oscillates in a fairly narrow range above 7 percent — has waned:

JPMorgan

Though this metric has shown signs of picking up recently, it's far too soon to call it a trend, according to Mellman.

And these developments run contrary to what the economist would have assumed would happen a few years ago.

"If you had asked me three years ago, I would've thought it would be the case that for the first year or two of the expansion it'd be so hard to get a job that people wouldn't even bother to look, but then there'd be a rebound," said Mellman.

In addition, Mellman notes that those who have been out of work for a short time are increasingly more likely to find a job than those who are out of work for at least a year. The scarring effect of being out of work for an extended period is all too real, as employers tend not to prefer prospective workers with large gaps in their résumés.

No doubt, the aging population is a dominant structural dynamic exerting downward pressure on the participation rate, with boomers beginning to retire en masse. But even the unemployed are increasingly electing not to look for work, with more than 25 percent of people without jobs exiting the labor force on a monthly basis over the past six months.

So the long-term unemployed still have a very difficult time getting a job and a hefty portion of the unemployed are exiting the labor force. In light of this, proponents of a looming cyclical boost to U.S. labor supply would appear to be swimming against the tide.

The issue of whether or not people are encouraged to return to the labor force has implications for inflation, and in turn the outlook for monetary policy.

The Fed's economic forecasts assume that growth will keep chugging along at a little above 2 percent over the next few years without the unemployment rate falling significantly. As such, Mellman believes that one of two things can be inferred: Either the central bank expects productivity to pick up, or projects there will be an influx of people into the labor force. Robust labor force growth is a way to square the circle, so to speak, with monetary policy makers' forecast that the unemployment rate will stay at extremely low levels without a commensurate pickup in inflation.

Mellman doesn't expect to see very extreme inflationary pressures arise any time soon. But given his skepticism about the potential for a cyclical uptick in the labor force participation rate, there could be less room for the labor market to improve than the Federal Reserve currently thinks.

All else equal, if workers aren't lured off the sidelines by the prospect of an easier job search, the U.S. economy will reach a level that constitutes full employment sooner, at which point an inflationary impulse would become more prominent.

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