If the lagging labor force rate doesn’t still embody considerable slack, then why does it increasingly predict wage growth?

September 22nd, 2014 at 8:16 am

Here’s another salvo in the great labor force slack debate.

Summarizing what is now a large and growing canon, a lot of digital ink has been spilled over three measly percentage points. That’s the amount the labor force participation rate (LFPR) is down from its pre-recession peak of about 66%, and the big question is how much of it is cyclical and how much structural. The intuition is that the cyclical part—a function of continued job market slack—can be restored while the structural part is gone.

Most work suggests the cyclical part of the gap is falling over time and is now quite minimal, as both the recovery takes hold and “scarring” effects make it tougher for labor force exiters to find their way back into the job market. However, a look at the relationship between the LFPR and wage trends suggests this conclusion may be premature.

A few months ago I reported on some important work by Blanchflower and Posen (B&P) showing that the decline in labor force helped to explain wage trends. Why should this matter? As I wrote back then:

B&P’s finding that including labor force inactivity in their wage analysis helps explain some of the variation…has a very important implication.  If the depressed labor force is a statistically identifiable contributor to slack, then some of the current labor force inactivity can be reversed, much the same way unemployment comes down in the face of strengthening labor demand.  Or, put differently, part of the decline in the labor force is just slack that’s not measured by the unemployment rate.

Here, I’d like to expand a bit on that insight.

First, updating some analysis from a few months ago, see the first figure below. In an analysis designed to show that the unemployment rate still retains some validity as a measure of labor market conditions, Goldman Sachs economists showed how it correlates with recent wage trends (the wage trends are a pooled version of five different series). However, as the red line shows towards the end of the figure, using just unemployment leads to an upwardly biased forecast in recent data. This is not unexpected, as the jobless rate has fallen faster than the underlying slack, a point Chair Yellen frequently makes and a reason she uses her dashboard and other data mashups.

lfpr1

Source: see text

Following B&P, the green line adds the labor force participation rate (LFPR) to the model, which tracks the wage trends more closely and underscores B&P’s point about the cyclical component of today’s LFPR. Even in this toy model, it significantly improves the fit (B&P create a state panel that generates much more data and variance; that’s a much better approach to what I’m showing here—though even this bit of blog-o-metrics makes the point, IMHO).

The next two figures add to the analysis and raise some new points. The first figure shows the coefficient on the LFPR from a “rolling regression,” where starting in 2009q1, I add one quarter at a time. So the first data point in the graph is the coefficient from a model running from 1995q1-2009q1; the second data point is from a model that runs from 1995q1-2009q2, and so on.

Note how the LFPR coefficient climbs as observations are added over the past few years, suggesting that at least in terms of its correlation with wage growth, the cyclical component of the LFPR is growing over time, a finding that stands in contrast with much more detailed decompositions of the LFPR.

lfpr2

Source: see text

Of course, statistical significance matters and the next figure shows the t-statistics from the LFPR coefficients in the prior figure. Importantly, they start out insignificant but gain significance as the weak recovery proceeds, again suggesting that the LFPR is increasingly correlated with the weak wage trends. (Note: As a “falsification test” I ran this model using data back to  the early 1980s and found the LFPR was insignificant and “wrong-signed.”)

lfpr3

Source: see text

While such simple modelling can only be called suggestive, both the increase in magnitude of the LFPR coefficients and its t-stats suggests that our depressed labor force embodies identifiable slack and that Chair Yellen is correct when she argues that a stronger labor market could likely pull some of those sideliners back in.

Data note: the model regresses the pooled wage trend on a constant, the unemployment rate, the LFPR, and an AR(1) term needed to whiten the residuals. I’ll post the data later so others can play with them.

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5 comments in reply to "If the lagging labor force rate doesn’t still embody considerable slack, then why does it increasingly predict wage growth?"

  1. smith says:

    Missed this link previously, topic of this blog on and off, getting some of the attention it deserves here and there:
    http://www.nytimes.com/2014/09/18/opinion/deciding-who-gets-overtime-pay.html
    Interesting to note:
    “Another problem is that government policy in the Obama administration is often debated and developed by people who were once 80-hour-a-week young professionals themselves, and thus may be susceptible to the argument against an appreciably higher salary threshold.”

    It’s a comment on the possibility a conservative economic framework becomes harder to reverse because a whole generation now only knows that existences. If you were born in 1958, towards the end of the baby boom, you graduated college in 1980, the year of Reagan, you are 56 years old, and have only known the dominant conservative agenda of the late 20th, early 21st century. Obama is a variation of Clintonism, which seeks to govern by making the Democratic party a centrist coalition, giving diproportionate influence to blue dog Democrats, though fewer in number, making the alternative to conservative economics, Republican light. Hence no debate over stimulus or deficit spending. Gradually, new deal reforms come creeping back as a few technocrats learn to reverse the tricks played even very recently by that genius Bush II (whose legacy of tax cuts endure 80% though I haven’t run the figures myself)


  2. Robert Salzberg says:

    TItle typo?

    “If the lagging labor force rate doesn’t still embody considerable slack, then why does it increasingly predict wage growth?”

    If there is no slack, wages should go up, right?

    Am I missing the point?


    • Jared Bernstein says:

      It’s just a terrible title, that’s all. But it’s supposed to be pushing back on the notion that the LFPR is depressed for purely structural, as opposed to cyclical, reasons. I’m rewriting this for a WaPo feature and will surely improve the title!


  3. John Daschbach says:

    Brad DeLong wrote an excellent piece related to this I am sure Jared has read.

    http://equitablegrowth.org/2014/09/22/potential-output-total-factor-productivity-since-2000-marking-beliefs-market-honest-broker-week-september-26-2014/

    It seems the quote from John Fernald at the end of the article is important here:

    “And my informal polling of firms doesn’t suggest a lot of slack within companies—they’ve adjusted to the weakness of demand by reducing headcounts and capacity. So you might be offended by the [sharp, sudden] changes in trend, but they’re in the data [and in the world out there].”

    A developed economy can equilibrate at a wide range of employment-population levels since most of production goes towards wants (e.g. iPhones) and not needs (food) but with different total output levels and growth rates. If, as seems possible, we are in a long term trend towards a (Perhaps pseudo stable) lower output level then the 2nd derivative is negative and using an AR(1) model is not appropriate.

    The demand and supply side are coupled through lagged differential equations, so it’s easily possible to have wage pressure even in a decreasing trend as long as the time constants are separated.


  4. urban legend says:

    “Structural reasons” cannot explain a drop of 5 million people out of the workforce in three years, or 3 million in 10 months. I don’t have to be polite to professional colleagues: there is no legitimate “debate” here.


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