One of the main indicators affecting the Federal Reserve’s decision of whether or not to raise interest rates is the unemployment rate. During periods of strong economic growth and falling unemployment, the Fed is more likely to raise interest rates to cool wage growth and keep a lid on potential inflation. However, officials are more likely to lower rates during periods of weakening economic activity and rising unemployment to spur economic growth.

Yet, unemployed persons finding new jobs is not the only way in which the unemployment rate can fall. It can also fall because some of the unemployed are no longer looking for work and have dropped out of the labor force altogether. If so, then a falling unemployment rate is not necessarily an indicator of renewed economic strength, but could indicate structural weakness within the job market.

Understanding Unemployment Statistics

In order to understand how the unemployment rate is affected, it is important to know how it is calculated. The U.S. Bureau of Labor Statistics (BLS) classifies all persons over the age of 16 as “unemployed if they do not have a job, have actively looked for work in the prior four weeks, and are currently available for work.” The labor force is defined by the BLS as “all persons classified as employed or unemployed.” Lastly, the unemployment rate is then calculated by dividing the total number of unemployed by the total labor force. 

Key Takeaways

  • The unemployment rate is a deciding factor for the Federal Reserve when setting interest rates.
  • Higher levels of unemployment might motivate the Fed to lower rates and spur economic growth, while low levels of unemployment might motivate higher rates to curb wage inflation.
  • Yet, the relative level of unemployment is important, the labor participation rate is a factor as well.
  • Labor participation considers people that have stopped looking for work and represents numbers that are not captured in unemployment rate statistics.
  • A low labor participation rate can hint at structural weakness in the job market.
  • Since 2010, the unemployment rate has declined, but so too has the labor participation rate.

From this, we can see that there are a number of ways in which the unemployment rate could fall. First, the most obvious way is that unemployed people find jobs and become employed. Labor force participation remains the same, while the number of unemployed decreased and the number of employed increased.

The second way is that people not currently counted in the labor force become employed. It is always possible for someone not actively looking for work to accept a job offer. As this would cause an increase in the total labor force while the number of unemployed remains unaffected, the percentage of unemployed would decrease.

Finally, the unemployment rate can fall when those once considered unemployed stop looking for work, and leave the labor force altogether. These people may want work and are available to work but have given up looking. As both the number of unemployed and total labor force decrease in such a situation, it may not be obvious that the unemployment rate actually goes down. But considering the most extreme example of all those currently unemployed leaving the labor force, no matter how low the total labor force falls, the unemployment rate falls to zero.

While the first two ways in which the unemployment rate could decline are positive signs of economic strength, the final way is actually more indicative of weakness. Let’s look at the U.S. situation in order to determine whether the falling unemployment rate is a sign of strength or a sign of weakness.

The U.S. Employment Situation

In 2010, the U.S. unemployment rate was sitting at 5%. Over the next couple of years it dipped below 5%, reaching a low of 4.4%, before beginning to rise after the global financial crisis in 2008. After reaching a high of 10% in October 2009, the unemployment rate has steadily fallen and, by mid-2019, was at 49-year lows of just 3.7%.

Yet, the above discussion on how the unemployment rate is calculated, and factors that could affect its fall, should be reason to be somewhat skeptical of extreme unemployment numbers. In fact, there is another trend that makes the sharp decline in the unemployment rate look a lot less rosy.

Since about the middle of the 1960s until around the year 2000, the labor force participation rate—labor force divided by the population—rose rather dramatically from just under 59% to more than 63%. One of the main contributors to this rise was the increasing rate at which women were joining the labor force. However, the rate is well below the levels of 66% seen in 2007 because, in the aftermath of the global financial crisis, the downward trend sped up significantly.

While many economists argue that this decrease in labor participation since 2007 is partly due to many of the baby boom generation starting to retire and leaving the labor force, the prime working age (25 to 54 years) labor force participation rate has also declined. It is now 82% (up from 80.6% in Sept. 2015) compared to 84% in the year 2000. Thus, retiring baby boomers cannot be the sole reason for the decline in the overall labor force participation rate since the financial crisis.

151,945,000

The number of jobs in the United States in Oct. 2019, up from under 130,000,000 in Oct. 2009

The fact that some people in their prime working age have left the labor force is more of a likely indication of a weakness in the U.S. labor market. One of the best explanations is that there is a skills-to-qualifications mismatch. Thus, despite the number of people who might want a job and are available for work, if they don’t have the skills that employers are looking for, they won’t get hired. 

The Bottom Line

While it may be tempting to think that a drop in the unemployment rate is a positive sign, the very narrow definition of the officially unemployed is evidence that the interpretation of unemployment rate trends is not unambiguous. One also needs to consider the labor force participation rate. If the unemployment rate is falling because people have given up on trying to find a job rather than actually finding a job, it is hard to see how this is evidence of a strengthening economy and reason for substantial changes in interest rate policy.