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Must-know: Labor market slack and why the Fed wants to handle it

Phalguni Soni

Overview: Takeaways from Janet Yellen's speech at Jackson Hole (Part 5 of 9)

(Continued from Part 4)

Labor market slack

In 2014, the unemployment rate fell faster than the Fed expected. However, other labor market indicators gave mixed readings. The Fed looks at these indicators before it contemplates raising rates.

Markets watch signals for an increase in the federal funds rate. This has important implications for both stock (DIA) and bond (BND) investors. Fixed-income markets, including Treasuries (IEF) (TBT) and high-yield bonds (HYG), are particularly sensitive because bond prices fall when rates rise and vice-versa.

Workforce participation 

The level of workforce participation is one of the most important factors in the job market. Workforce participation is the number of people actively seeking employment divided by the number of people willing and able to work. It determines the amount of labor market slack.

Labor market slack implies that the available workforce isn’t being utilized. Labor market slack indicators include:

  • People working part-time when they would really prefer to work full-time.
  • Workers getting discouraged and exiting the workforce altogether because of poor labor market conditions.
  • People who are unemployed long term finding it harder to enter the workforce because of skill erosion. Their existing abilities aren’t being fully utilized.
  • The number of disability insurance applicants increasing.

Labor market slack can artificially depress the unemployment rate—a key determinant of the Fed’s monetary policy. During a recovery, some of these workers may return to the labor force—for example, discouraged workers. This would increase workforce participation. It would also increase the unemployment rate, unless the economy created enough jobs to absorb the returning workers.

We’ll discuss Janet Yellen’s take on the current evidence of labor market slack in the next part of the series.

Continue to Part 6

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