Wednesday, April 16, 2014

The deceptively strong 1st quarter

With the unemployment rate stuck at 6.7%, where it was in December, one might be tempted to think that the labor market is going through a period of weakness.  It turns out that 2014 1Q has seen a large upswing in labor force participation.  Here is a chart showing the employment-population ratio (EPR) and the labor force participation rate (LFP).

The purple line is the LFP trendline.  In other words, that is what labor force participation would be if the LFP of each age group followed long term trends.  This is what LFP would be without cyclical fluctuations.  So, we can see that LFP has dipped below trend, which is normal for a recession.

The Unemployment Rate is the difference between the EPR and the LFP (with the LFP as the denominator).  What we can see in the graph is that the past 6 months have seen an impressive uptick in both employment and LFP (the downtick in October was related to the government shutdown).  The household survey has reported a gain of over 1.1 million jobs in the 1st quarter.

That little green line at the end is the LFP that would correspond to a 6.0% unemployment rate, given the recorded EPR.  In other words, if LFP hadn't jumped so much this quarter, unemployment would nearly be down to 6.0% in March.

Now, there is a lot of noise in the household data.  But, even if we assume this is noise, and adjust LFP back down to the short term trend, unemployment would have fallen to below 6 1/2% by March, given the statistical relationship between short term noise in the EPR and LFP series.

April 2010 was the last time this sort of jump happened in LFP, and the unemployment rate dropped by 0.5% over the next two months.

The pessimistic reading of this would be that LFP has been running parallel to the trend LFP for the past two years, except that the LFP in 2013 4Q was a negative statistical outlier, so that the reported December 2013 unemployment rate was too low, and now the LFP has recovered to the short term trend.  This interpretation would mean that the current 6.7% unemployment rate isn't inflated, but we would still be looking at a good trend in EPR.

I suspect that this is partly statistical noise and partly a maturation of this cycle, where the LFP will begin to move back toward trend.  In light of the demographic trends, a sideways EPR is enough for a recovery, so if we see a sustained positive trend in EPR, this should be a very good sign for the economy.

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