GDP and labor market data couldn’t be telling a more different story. GDP contracted -2.9% in the first quarter even though we’ve added 231k jobs per month on average in 2014, dropping the unemployment rate from 6.7% at the end of 2013 to 6.1%. What’s going on?
On one hand, payroll growth has been remarkably consistent (since 2011, the 12 month moving average has oscillated between 169k and 205k) and moderately healthy (we finally exceeded our previous peak in jobs despite the large wave of Baby Boomers retiring and reductions in government employment – specifically on the local level).
Meanwhile, the disappointing Q1 GDP report once again demonstrated the economy’s tendency to over-promise but under-deliver. Economists – both on Wall Street and at the Federal Reserve – have repeatedly called for a strong pickup in output growth, yet have had to curb their enthusiasm each time. And while a number of negative “transitory” shocks all struck in Q1 (economists expect GDP to rebound in Q2), the recurring disappointment calls into question the underlying fundamentals of the US economy.
So, in the absence of any shocks to the economy (from diminished government spending or a bitter winter, for example), how fast is the economy able to grow?
One relatively straightforward approach – which helps consolidate the dichotomy in data described above – is to aggregate the number of hours that the American labor force can work as well as the amount of “stuff” each worker can produce or provide per hour. Aside from its simplicity, a benefit of this approach is that it allows us to quantify two issues very much in vogue: the aging of the population and the prevalence of part-time workers for economic reasons.
While this analysis abstracts over some secular shifts (such as the increased likelihood of the young to extend their education and the small expected shift towards part-time work due to the Affordable Care Act), it does provide a baseline for measuring the output gap from a labor perspective. We can also further refine our estimate of slack by augmenting this tops-down approach with the bottoms-up analysis I’ve written about in the past.*
This exercise shows us that trend growth has slowed some. The aging of the population has and will slow labor force growth, reducing future potential output. In addition, given relatively low investment spending, productivity growth may also be more tepid going forward, further downgrading potential growth. The CBO, using a similar approach, estimates that trend growth will average just above 2% over the next 10 years, below the 2.5% trend growth in the early naughts and over 1% lower than in the 90s.
Yet even though the bar is now lower, a large gap still exists. And this analysis highlights the cyclical nature of the shortfall – a lack of demand for hours. I’ve argued in the past** – and research from the Federal Reserve banks has reached similar conclusions – that the labor market weakness (aside from the large role of demographics accounted for in the analysis above) is largely cyclical. In addition, recent research has shown that the long-term unemployed are largely indistinguishable from the short-term unemployed in terms of age, sex, education and occupation – they’re just unlucky. And while a mix of hysteresis (skills deterioration) and bias against the long-term unemployed may keep these potential workers from finding jobs, high unemployment rates remain attributable to the lack of demand.
Finally, the cyclical origin of the output gap is corroborated by the lack of wage growth. Indeed, even the recent “acceleration” in one measure of wages (other more comprehensive measures have been steady) simply got us closer to the “correct” amount of wage growth as implied by the unemployment gap. In fact, given how close the unemployment rate is to the CBO’s estimate of the neutral rate, wage inflation should be higher – implying that labor slack is higher than the standard measure.
Yet there is no denying that we are getting closer to a healthy economy and while the Fed may not be ready to hike rates just yet, you can bet Yellen is looking over the data and humming along to Frankie Valli: “Yea I’m workin’ my way back to you babe and the happiness that died.”