Notes: URAP Project 3: Fall 2005: Analyzing the Cyclical State of the Labor Market

Looking at the unemployment rate, today's U.S. labor market looks relatively strong:

Looking at the fraction of people at work, today's U.S. labor market looks relatively weak:

If the U.S. labor market is relatively strong, it is appropriate for the Federal Reserve to keep raising interest rates in order to prevent the emergence of an inflationary spiral and the resulting creation of fear that the Federal Reserve is not an effective guardian of price stability. If the U.S. market is relatively weak, there is no need to fear wage-push inflation, and it is appropriate for the Federal Reserve to cut interest rates in order to stimulate demand and get the economy closer to full employment. But our two main indicators disagree.

One way to gain more information about what is "trend" and what is "cycle" is to take a look at other time series indicators that we believe have a similar cyclical component. When the labor market is cyclically strong, we believe that the unemployment rate will be lower than trend, that the employment-to-population ratio will be higher than trend, that average hours worked will be relatively high (since firms are likely to increase both bodies and hours when their demand for labor is strong), and that the average duration of unemployment will be relatively low (because more of the fluctuations in quits, firings, and hires that drive the employment side of the business cycle are on the hires side). We know what unemployment and the employment-to-population ratio look like. What do these other two series look like? Here they are:

The issue at stake is essentially whether the past five years have seen a stable value for the trend unemployment rate and a fall in the underlying trend for the employment-to-population ratio (meaning that our current employment-to-population ratio is actually close to, not far below, the long-run trend) or whether the past five years have seen a stable value for the trend employment-to-population ratio and a fall in the underlying trend value for the unemployment rate. The weekly hours series and the unemployment spell duration series seem to vote with the employment-to-population ratio: three series seem to say that the current cycle component is large, that there has been only a smell recovery from the business cycle trough levels, and that we are still pretty far away from full employment. Only one indicator--the unemployment rate--seems to say that recovery is well advanced and that the cyclical component has substantially shrunk.

This, however, doesn't resolve the mystery: why is the indicator that is the unemployment rate giving a different signal? What has happened to keep workers whom we would have expected--given the behavior of unemployment spell duration, hours, and the employment-to-population ratio--to say that they are unemployed from saying so when the CPS interviewers come to call?

Some serious quantitative work on this would be genuinely useful--and could easily be done within the framework of a URAP