CRS – Returning to Full Employment: What Do the Indicators Tell Us? Marc Labonte, Specialist in Macroeconomic Policy. April 15, 2014.

“Until recently, the economy and labor market were experiencing an unusually slow recovery from the longest and deepest recession since the Great Depression compared to other expansions since World War II. The rapid decline in the unemployment rate from 7.9% in January to 6.7% in December 2013 (where it remained in the first quarter of 2014) would seem to indicate that the labor market is returning to normal. The current unemployment rate is only 0.5 to 1.5 percentage points higher than the consensus range of full employment. Unusually, the unemployment rate may not currently be a good proxy for the overall state of the labor market or economy. Some of the decline in the unemployment rate in 2013 is attributable to a recovery in employment, but some is attributable to workers dropping out of the labor force. The labor force participation rate has continued to fall during the recovery and is at its lowest level since the 1970s. In fact, it has fallen more in the past five years than at any time since data have been collected. Studies have identified multiple reasons for the decline. Some workers have left the labor force because they have become discouraged and given up on seeking employment. Others have left for reasons stemming from long-term trends that are unrelated to the recession, such as age or enrollment in school or training. This trend could reverse—for example, more workers returned to the labor force than found jobs in the first quarter of 2014, which prevented the unemployment rate from falling. Other evidence also points to more slack in the economy than the headline unemployment rate suggests. Economic output and employment have grown since mid-2009 and 2010, respectively, but at relatively sluggish rates. The long-term unemployment rate and youth unemployment rates have fallen only modestly since the recession ended and are still at historically high levels. Inflation has remained slightly lower than the Federal Reserve’s (Fed’s) goal of 2%. These other economic indicators could be sending a misleading signal about significant slack in the economy, however, if the economy’s potential capacity has been eroded by structural changes or by the length and depth of the Great Recession. Cyclical deterioration in the U.S. labor market is usually considered temporary—recessions are thought to have no lasting effect on overall employment and unemployment rates. This recession could cause a departure from conventional wisdom if labor market problems that started as cyclical persisted so long that they became structural. For example, long-term unemployment could have caused workers’ skills to erode, which would then prevent them from finding a job when the economy recovered. Congress conducts fiscal policy and oversees the Fed’s implementation of monetary policy, the two tools of macroeconomic stabilization. Policy makers are grappling with the transition from the highly expansionary monetary and fiscal policy put in place during the Great Recession. Many economists advocate reducing the budget deficit only when the economy is at or near full employment. Likewise, the Fed has stated that it would begin to raise interest rates once the economy is near full employment. If the economy remains far from full employment, then declining unemployment would not yet call for a tightening of monetary and fiscal policy. Alternatively, if lower unemployment is being driven by a cyclical upswing and the economy is now closer to full employment than historical experience would predict, policy would likely need to be tightened sooner in order to avoid rising inflation. It would also suggest that structural policies (e.g., those that increase the incentives to hire, seek work, delay retirement, or train) would be more effective at improving labor market conditions than counter-cyclical monetary and fiscal policies.”