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Why The Unemployment Rate Fell: Dipping Participation Rate

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Jan. 7 2015, Published 5:07 p.m. ET

Labor markets are weaker than they appear, leading the Fed toward continued accommodative monetary policy. Still, the central bank may find that weakness difficult to overcome, as much of it stems from serious long-term issues and not merely short-term lack of demand.

In recent posts, my colleague Russ Koesterich outlined why the U.S. labor market recovery will continue to frustrate the Fed, and Jeff Rosenberg examined one key reason why the central bank is set to keep rates low for some time. I agree with these points, and want to step back and talk about some of the long-term structural headwinds that labor markets face today.

First, let’s take a look at the official statistics. While headline unemployment has been declining for the last three years, looking at the official unemployment rate as a signpost for the overall health of labor markets is highly misleading. Indeed, both investors and the Fed itself are increasingly focusing on a broader array of labor market metrics. Chiefly, and unfortunately, much of the decline in the unemployment rate can be attributed to the fact that more and more people are dropping out of the labor force (shown in the chart below via the decline in the participation rate).

That is hardly the sign of a thriving employment environment.

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Market Realist – Dipping participation rate has led to artificially low unemployment rate

The graph above shows the labor force participation rate, the unemployment rate, and what the unemployment rate would have been if it included the effects of a dipping participation rate, which is close to its 35-year low. The slide in the unemployment rate is partly due to the workers getting discouraged, that is, getting out of the labor force. This is not a good sign.

This, along with anemic wage growth, has had an adverse impact on disposable income. Low disposable income, in turn, has negatively affected sectors like the consumer staples (XLP) and consumer discretionary (XLY).

The Fed could keep interest rates low to support the labor market. This could keep Treasury (TLT) and corporate bond (AGG)(LQD) yields low for a while.

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