Significant Amount of Slack Remains in the Labor Market

by Congressional Budget Office

Although conditions in the labor market have improved notably in recent quarters, a significant amount of slack remains, in CBO’s estimation. As discussed in a blog post last week and in our updated budget and economic outlook, CBO anticipates that economic growth will pick up in the next few years. That faster growth will reduce the amount of slack in the economy. Similarly, in CBO’s judgment, ongoing gains in employment will largely eliminate the existing slack in the labor market during the next few years.

Broadly speaking, slack in the economy refers to underutilized productive resources, including business equipment and structures that are idle, houses that are unoccupied, and people who would like to work but are not working (or who are employed but would like to work longer hours). In CBO’s view, the current slack in the labor market consists of several elements, including the following:

• The labor force participation rate is well below what CBO estimates would be achieved if the demand for workers was currently stronger—that is, well below the potential participation rate that reflects the estimated effects both of demographics (such as the age distribution of the population) and of the number of people who have left the labor force permanently in response to the recession and slow recovery;
• The unemployment rate is above CBO’s estimate of the natural rate (that is, CBO’s estimate of the unemployment rate arising from all sources except fluctuations in aggregate demand);
• In combination, the shortfall in labor force participation and the elevated unemployment rate have resulted in substantially lower employment in 2014 than would otherwise be the case; and
• The share of part-time workers who would prefer full-time work is significantly higher than it was before the recession, and the rate of long-term unemployment is still about a percentage point above its average rate during the years before the recent recession.

One important signal that significant slack remains in the labor market is continued slow growth in hourly labor compensation. But measuring slack is quite difficult—especially given the unusual developments in the labor market since the recession ended—and the current amount of slack could be a good deal larger or smaller than CBO estimates.

Labor Force Participation Rate

The labor force participation rate fell from 65.9 percent in the fourth quarter of 2007, at the beginning of the recent recession, to 62.8 percent in the second quarter of 2014.

CBO estimates that about ¾ percentage point of the decline since late 2007 represents the extent to which actual participation is below potential participation because of the contemporaneous weakness in both employment prospects and in wages. That amount is only slightly less than the effect CBO estimates for the fourth quarter of 2013, when the estimated shortfall of the actual participation rate relative to the potential participation rate was at its largest.

According to CBO’s analysis, most of the decline in the rate of labor force participation since late 2007 is attributable to two other factors: First, long-term trends, especially the aging of the population, account for about 1½ percentage points of the decline. Second, unusual aspects of the slow recovery of the labor market that led workers to become discouraged and permanently drop out of the labor force account for about ¾ percentage point of the decline.

Unemployment Rate

The unemployment rate stood at 6.2 percent in the second quarter of this year, roughly 1¼ percentage points above its level before the recession (see the figure below).

CBO estimates that about ½ percentage point of that increase reflects temporary cyclical weakness in the economy—much less than the peak effect of temporary weakness, estimated to be about 4¼ percentage points in late 2009. In CBO’s view, the remaining ¾ percentage point of the increase from the unemployment rate before the recession stems primarily from two structural factors that have boosted the natural rate of unemployment to about 5¾ percent currently:

• The stigma and erosion of skills that can stem from long-term unemployment (wherein a person has been jobless for more than 26 consecutive weeks) account for about ½ percentage point of the increase; and
• A decrease in the efficiency with which employers are filling vacancies (probably at least in part as a result of mismatches in skills and locations) accounts for about ¼ percentage point of the increase.

Employment Shortfall

In the second quarter of this year, if the unemployment rate had returned to its prerecession level and if the labor force participation rate equaled its potential rate, about 3¾ million more people would have been employed, according to CBO’s estimates. The elevated unemployment rate and the depressed labor force participation rate account for that shortfall in roughly equal proportions. By comparison, the shortfall in employment represented about 5¼ million people in the fourth quarter of last year by CBO’s estimates, reflecting a higher unemployment rate and a slightly more negative effect of the cyclical economic weakness on labor force participation. At its peak in 2009, that shortfall was 8½ million people, CBO estimates.

Those estimates of the shortfall in employment do not reflect the number of people who have left the labor force permanently in response to the recession and slow recovery. However, the estimates do include unemployed workers who would have difficulty finding jobs even if overall demand for workers was higher. Alternative measures of the shortfall in employment that treated those or other groups of people differently might be appropriate for some purposes.

Other Indicators of Labor Market Slack

Another manifestation of slack in the labor market is the number of people who are employed but are not working as many hours as they would prefer. The incidence of part-time employment for economic reasons (resulting from slack work or business conditions or a worker’s inability to find full-time employment) remains much higher than it was before the recession (see the figure below). Consequently, the Bureau of Labor Statistics’ U-6 measure of underutilization in the labor market stood at 12.2 percent in the second quarter, down from a peak of 17.1 percent in fourth quarter of 2009 but still well above its value of 8.5 percent in the fourth quarter of 2007. (The U-6 measure combines the number of unemployed people with numbers for two other groups of people: those who are “marginally attached” to the labor force—that is, who are not currently looking for work but are willing and able to work and who have looked for work in the past 12 months—and those who are employed part-time for economic reasons.) Consistent with the trends in the U-6 measure, average hours worked per worker fell substantially during the recession and remain below their prerecession level.

Although the rate of short-term unemployment (the number of people unemployed for 26 weeks or less as a percentage of the labor force) in the second quarter of 2014 was close to its average rate between 2001 and 2007, the rate of long-term unemployment was still about a percentage point above its average rate during that earlier period (see the figure below). The fact that the elevated amount of unemployment is concentrated among the long-term unemployed has accentuated concerns that stigma and an erosion of skills may be hindering their efforts to secure stable work. Although CBO estimates that those factors have raised the natural rate of unemployment, the agency nonetheless expects that many of the long-term unemployed who are not near retirement age will be employed again. CBO’s view reflects recent research that the long-term unemployed are in many ways similar to people who have been unemployed for a shorter time. Moreover, the rate at which the long-term unemployed find jobs, while still quite low, appears to have picked up in recent months.

Finally, labor compensation (the combination of wages, salaries, and benefits paid to workers) has grown slowly, another indication that a significant amount of slack remains in the labor market.

Difficulties in Measuring Labor Market Slack

Considerable difficulties arise in measuring slack in the labor market, especially under current circumstances. For example, in estimating potential labor force participation, CBO has estimated how many people permanently dropped out of the labor force because of such factors as long-term unemployment. However, CBO may have underestimated or overestimated that number, and therefore potential labor force participation could be higher or lower than the agency thinks. Similarly, CBO’s estimate of the increase in the natural rate of unemployment relative to what it was before the recession incorporates the agency’s estimate of the decrease in the efficiency with which employers are filling vacancies. That effect has diminished gradually, in CBO’s judgment, as the causes of that dampened efficiency have receded and as workers have acquired new skills, shifted to faster growing industries and occupations, or relocated to take advantage of new opportunities. If such adjustments in the labor market have occurred faster or slower than CBO has estimated, the natural rate of unemployment would currently be lower or higher, respectively, than CBO has estimated. A lower natural rate would suggest less upward pressure on wages for any given unemployment rate, and a higher natural rate would suggest more upward pressure.

Source: http://www.cbo.gov/publication/45683

Author: Bob Arnold is Chief of the Projections Unit in CBO’s Macroeconomic Analysis Division.