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Unemployment and the markets: Do the numbers add up?

April 29, 2014

Are people out of work because the U.S. economy still hasn't strengthened enough to employ more of those who are looking? Or would many people remain out of work even if hiring improved because they lack the education and skills the new jobs require?

It's one of the biggest questions facing policymakers: Whether unemployment remains high because of cyclical factors (a weak economy) or structural factors (unmatched skills)? The difficulty of finding an answer complicates the task the Federal Reserve faces in exiting its massive bond-buying strategy and deciding when to raise interest rates. Depending on the measure, true unemployment could be much higher than is being widely reported.

Update: June 6, 2014

Jobs picture continues to brighten

As of May, the U.S. labor market has recovered 8.7 million lost jobs and returned to pre-recession levels. Employers added 217,000 jobs in May, about what economists anticipated. The unemployment rate remained 6.3% after dropping 0.4% in April, and the number of unemployed was also unchanged at 9.8 million. Compared with a year ago, the unemployment rate was 1.2 percentage points lower and the number of unemployed fell by 1.9 million.

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Charles Thomas"Until recently, the Fed was focused on the official unemployment rate in its communications. It stepped back from this at its last meeting, likely because the unemployment rate by itself is rather difficult to interpret in the current environment," said Vanguard investment analyst Charles Thomas.

"Participation in the labor force has dropped significantly over the past several years, reflecting the fact that many unemployed workers have simply given up looking for work, falling out of the official unemployment calculations," he said. "The key question for the Fed is: Will these workers come back when things improve?"

Here's the problem: Numbers that capture unemployment can be challenging to interpret. The official rate moves markets and can sweep presidents out of office, but determining what this measure means can be a subtle exercise with crucial implications for the health of the economy. If the Fed raises rates too soon it could choke off the recovery. If it waits too long, it could feed inflation.

So let's start with the current unemployment rate: Is it 6.7%, the official rate in March 2014, which includes just those who are actively looking for work? Or is it 12.6%, the number that takes into account people who are so discouraged that they've stopped looking, along with those who want full-time jobs but are currently working only part-time?

In reality, both measures are imperfect.

If, because of a weak job market, an older worker decides to retire early or a student decides to stay in school longer, unemployment measures will not capture them because they are not counted as part of the labor force.

Demographics and structural change cast doubt on unemployment rate

Unemployment rate under hypothetical scenarios for labor force participation

Unemployment demographics chart

Notes: Figure displays the official unemployment rate along with three adjusted measures. The red line assumes the labor force participation rate stays constant at the December 2007 level of 66%, with any labor force dropouts being added to the unemployment calculation. The green line assumes labor force participation is held at December 2007 levels but controls for the impact of demographics, with workers shifting to and from age groups with different participation rates. The gold is our estimate of the true unemployment rate, which accounts for demographic changes in the population and also fits a trend in labor force participation rates across ten demographic groups from 1998 to 2007, to control for time-varying structural changes in the labor market. Sources: Vanguard calculations, based on data from the U.S. Bureau of Labor Statistics and the U.S. Census Bureau.

Participation in the labor force has fallen since the recession

Labor force participation rate, 1990–2014

Unemployment participation chart

Note: Figure displays the labor force participation rate from January 1990 to January 2014.

Sources: Vanguard calculations, based on data from the U.S. Bureau of Labor Statistics.

As these charts show, the big decline in the labor force participation rate may mean the rate of unemployment is understated. Vanguard estimates that a cyclical downturn (e.g., weak demand, returns to school by people who would prefer to work) accounts for about half of the drop in the participation rate, while the other half of the decline can be attributed to more permanent, structural issues (e.g., skill mismatches, an aging population).

This estimate would put the "true" unemployment rate at about 8%. Forming an opinion on the right number depends on determining how much of the drop in labor force participation is permanent. The Fed is also making these calculations, because they matter for inflation.

While Vanguard does not believe the current risk of inflation is high, the Fed must always guard against it, just as it must guard against deflation. If the fall in participation is more permanent (structural) than we currently believe, the Fed could be faced with the paradox of having to tighten policy even though the labor market seems weak, as employers boost pay to compete for the relatively small number of qualified applicants, creating inflation. Alternatively, if the fall in participation is mostly cyclical, then downward pressure on wages and inflation is likely as workers return to the labor market, with the Fed on hold for longer than many currently anticipate to avoid deflation.

Current debates about unemployment are more robust now than in easier economic times, but it's not as if this kind of uncertainty is new. We believe these questions only reinforce the value of maintaining a well-diversified portfolio rebalanced regularly.

For a more detailed discussion of the importance of the unemployment rate and Fed policy, and other issues influencing the economy and financial markets, read Vanguard's economic and investment outlook.


  • All investing is subject to risk, including the possible loss of the money you invest. Diversification does not ensure a profit or protect against a loss.
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