How close are we to full employment?

One of the most striking--and depressing--aspects of the great recession has been the collapse of the employment-population (E/P) ratio and its stubborn failure to recover. Unlike the conventional unemployment rate, which does not count discouraged workers as unemployed if they stop looking for work, the E/P accounts for discouraged workers and is thus often considered a superior indicator of aggregate labor-market conditions. By this metric, the recovery has a long way to go.

Or does it? E/P is experiencing an underlying downward trend as well as the cyclical effect of the recession. The trend change is due to falling labor-force participation, which in turn reflects changing demographics and to some extent changes in policies such as disability insurance. If the downward trend were strong enough, E/P might actually be a lot closer to "full employment" than it appears to be.

This post summarizes some recent work on the question, coming out of Federal Reserve banks. A key challenge is that the underlying "trend" E/P is not observed, but must be inferred; the assumptions that go into that inference matter. Furthermore, and perhaps less tractable, participation may be subject to hysteresis, meaning the trend may actually have been shifted by the depressed conditions of the recent period. If so, the past relationship between demographic characteristics and work behavior is not a reliable guide to the current relationship.

My read is that labor markets are not yet close to full employment, but the full-employment target is hard to locate with much precision. Giving the benefit of the doubt to the workers, at the very least monetary policy should remain loose until we see some serious evidence of wage inflation.