The issue
Recent bank research emphasizes weakening labor demand, noting that job gains are primarily driven by state and local hiring, while private-sector employment remains soft. Yet, labor supply has received less attention. The unemployment rate has been flat for several months, and labor force participation has ticked down, mainly due to foreign-born workers exiting the labor market. If both labor demand and supply are contracting, what is the likely path of the unemployment rate — higher, lower, or in line with the SEP?
FRB-US Based Analysis
We use the FRB-US model to assess the impact of negative labor supply shocks, implemented in two ways: (i) a reduction in the working-age population and (ii) a decline in the participation rate. Figure 1 compares the current baseline (red), a working-age population shock (grey scenario), and a participation shock (green scenario). Both shocks lower real GDP growth. However, only the population shock increases the unemployment rate; a participation shock decreases it relative to the baseline no matter the size of the shock.
Figure 1. Current baseline and two negative labor supply shock scenarios.
Note: the figures show the current baseline (red line) and two scenarios. Real GDP growth is expressed as YoY (%). The green lines assume a shock to participation rate as shown in Figure 2, while the grey lines assume a negative shock to the level of working-age population, again as shown in Figure 2.
Model Mechanics
Figure 2 displays the dynamics of participation, employment, working-age population, and labor force under both scenarios. Both shocks (shown in the upper and lower left panels) reduce employment and GDP. But the population shock reduces employment more than it reduces the labor force, pushing up the unemployment rate.
This happens because the model defines trend labor force as the product of trend participation and the working-age population. A shock to either reduces potential labor input and hours worked but the population shock has an additional effect: it lowers potential output and widens the output gap.
Figure 2. Current baseline and two negative labor supply shock scenarios – labor variables.
Note: the figures show the current baseline (red line) and two scenarios. The green lines assume a shock to participation rate as shown in the Figure, while the grey lines assume a negative shock to the level of working-age population, again as shown in the Figure.
Intuition
Both shocks are contractionary, but the population shock is more severe, as it reflects a literal reduction in the population — implying lower consumption and a structurally smaller economy. This is why the unemployment rate is higher than the baseline when we shock the level of working-age population.
Relevance to Current Conditions
(Note: this is our subjective opinion, not model based) While the outlook is uncertain, we believe participation shocks may dominate in the short term, whereas population shocks are more structural and likely to shape the long-term trajectory. Therefore, we perceive the risks around consensus for the unemployment rate to be skewed to the downside in the near-term and to the upside in the medium-term, conditional on the two shocks. And we suspect that movements in the unemployment rate might be less informative or intuitive than usual in the current environment.
We remind the reader that we run on-demand scenarios. Do not be shy!