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 people 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.

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 inflation.
  • While 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 the structural weakness in 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 and multiplying this number by 100 to calculate a percentage rate. 

Ways Unemployment Rates Can 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 decreases and the number of employed increases.

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.

Discouraged Workers

Finally, the unemployment rate can fall when those once considered unemployed stop looking for work and leave the labor force altogether. The BLS defines discouraged workers as people not in the labor force who may want work and are available to work but have given up looking. While they have looked for work sometime in the previous 12 months, discouraged workers are not counted as unemployed if they have not looked for work in the four weeks prior to the BLS survey.

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 a falling unemployment rate is a sign of strength or a sign of weakness.

The U.S. Employment Situation

In 2001, the U.S. unemployment rate was sitting at around 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 steadily fell and, by September 2019, was at 49-year lows of just 3.5%.

This trend changed dramatically in 2020 due to the COVID-19 pandemic and the unemployment rate quickly rose to 14.8% in April. However, by the end of 2020 and into 2021, the unemployment rate steadily decreased, registering at 5.9% in June 2021.

Yet, the above discussion on how the unemployment rate is calculated, and factors that could affect its fall, should be reason enough 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.

Labor Force Participation Rate

From about the middle of the 1960s until around the year 2000, the labor force participation rate—labor force divided by the noninstitutionalized, civilian working-age population—rose rather dramatically from just under 59% to more than 67%. One of the main contributors to this rise was the increasing rate at which women were joining the labor force. However, the rate fell steadily from the 66% to 67% levels seen until late 2008 in the aftermath of the global financial crisis.

While many economists argue that this decrease in labor participation since 2008 is partly due to many of the baby boomer generation starting to retire and leaving the labor force, the prime working age (25 to 54 years) labor force participation rate has also declined. In January 2021 it declined to 76.4% compared to 81.8% in the year 2000. Thus, retiring baby boomers cannot be the sole reason for the decline in the overall labor force participation rate.

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 explanation 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. Another explanation is the number of discouraged workers who have left the workforce due to circumstances surrounding the COVID-19 pandemic.

617,000

The number of discouraged workers in the U.S. in June 2021, up from 565,000 reported in April 2021.

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, this may be evidence of a weakening economy and may be reason enough to impact the Fed's monetary policy decisions.