The unemployment rate declined markedly in 2013, to 6.7% in December from 7.9% in January, seeming to signal that the labor market is approaching full employment. Other economic and labor market indicators paint a more pessimistic picture, however. It concludes by analyzing the implications of these developments for macroeconomic stabilization policy, as policy makers grapple with the transition from the expansionary fiscal and monetary policy put in place during the "Great Recession." If the labor market has experienced structural changes, it would also have implications for labor market and other microeconomic policies (e.g., spending or tax provisions that increase the incentives to hire, seek work, delay retirement, or train), which are beyond the scope of this report. Only the 1980s recovery faced a comparably long return to full employment, nearing full employment after 19 quarters. And, because the unemployment rate was so high at its peak in the Great Recession and has fallen slowly, it has been at historically high levels for most of the recovery. It has remained around that level in the first quarter of 2014. Since World War II, the participation rate has never before fallen significantly in an expansion and has exhibited only modest cyclicality —it declined by less than one percentage point during the 1980, 1991-1992, and 2001 recessions, and did not decline in the others. Workers can leave for various reasons, including retirement, injury or illness, family reasons, study or training, or because they have become discouraged and stopped looking for a job. It could be cyclical, caused by the Great Recession, or it could be structural, caused by long-term forces unrelated to the recession. The increase in workers classified by BLS as discouraged or marginally attached to the labor force, from about 1% of the labor force before the recession to 1.5% of the labor force since, is further evidence that some of the recent decline in the participation rate is cyclical. Some groups have lower employment and higher unemployment rates than the overall labor force, and these groups have experienced a weaker rebound during the economic recovery than the overall labor force. It then fell to 2.6% at the end of 2013; despite the decline, it remained higher than at any point from 1948 to 2008. The slow decline in the unemployment rate and continued lack of employment opportunities for youth and the long-term unemployed in the current recovery have raised concerns that the natural rate of unemployment may have risen recently. There are several other indicators of slack in the economy and the labor market, but, as long as those measures are relatively well correlated with the headline unemployment rate, as they typically are, the unemployment rate provides a simple rule-of-thumb gauge of how close the economy is to full employment. As this report has discussed, other indicators have diverged from the unemployment rate and suggest that significant slack remains in the economy. Policy makers have two macroeconomic stabilization tools, fiscal policy and monetary policy, at their disposal. Congress has delegated the operation of monetary policy to the Federal Reserve, but exercises oversight. A common view among economists is that the government should run deficits when the economy is far below full employment and balanced budgets or surpluses when the economy is near full employment. In other words, the Fed intends to raise interest rates only when it judges the economy to be closer to full employment. The current unemployment rate would seemingly call for a near-term tightening of fiscal and monetary policy. If there is still considerable slack in the economy, despite the decline in the unemployment rate, then tightening policy could be premature and there is less concern that continued stimulus would cause inflation to rise. This would be the case if structural changes or the Great Recession (i.e., hysteresis) permanently reduced the potential capacity of output and labor markets, so that the economy is no longer capable of returning to the historical trend.
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.