A Mis-Leading Labor Market Indicator

A Mis-Leading Labor Market Indicator
Samuel Kapon and Joseph Tracy
Liberty Street Economics, February 03, 2014

The unemployment rate is a popular measure of the condition of the labor market. With the Great Recession, the unemployment rate increased from a low of 4.4 percent in March 2007 to a peak of 10.0 percent in October 2009. As the economy recovered and growth resumed, the unemployment rate has fallen to 6.7 percent. What other measures are useful to supplement our understanding of the degree of the labor market recovery?

The employment-population (E/P) ratio frequently is used as an additional labor market measure. The E/P ratio is defined as the number of employed divided by the size of the working-age, noninstitutionalized population. An advantage of the E/P ratio over the unemployment rate is that it is not impacted by discouraged workers who stop looking for employment. The E/P ratio also dominates a measure focusing just on total employment in the economy, since it adjusts for changes in the size of the working-age population. The chart below shows the E/P ratio since 2001. The gray shading represents time periods when the economy was in a recession. Over the Great Recession, the E/P ratio (red line) declined by 4.1 percentage points relative to the average of the E/P ratio over the prior expansion (blue line). Since the end of the recession, the E/P ratio has largely remained constant—that is, virtually none of the decline in the E/P ratio from the Great Recession has been recovered to date. An implication is that the 7.6 million jobs added since the trough of employment in February 2010 has essentially just kept pace with growth in the working-age population.

In its failure to recover, the E/P ratio would seem to depict a much weaker labor market than indicated by the unemployment rate. An important question is whether this is a correct or a misleading characterization of the degree of the labor market recovery. While the E/P ratio is not affected by discouraged workers, it still is impacted by changing demographics in the economy. The employment rate profile over a worker’s career has an inverted U-shape, with rising employment rates until a worker reaches her mid-30s to mid-40s, then leveling off and declining in her 50s with sharp drops at 62 and 65. The effect of population aging on the E/P ratio depends on the distribution of individuals in the economy across the rising and falling sections of their career employment rate profiles. The earlier observation that no progress has been made in closing the E/P gap opened up by the Great Recession assumes that, in the absence of the recession, the E/P ratio would have remained relatively constant at the level indicated by the blue line in the chart. However, it is important to check this assumption by estimating the impact of changing demographics on the E/P ratio.

To explore this question, we take all individuals age sixteen or older from the Current Population Survey Outgoing Rotation Group samples from January 1982 to November 2013. This gives us monthly data with 10.2 million observations on individuals and their employment status. We divide these individuals into 280 different cohorts defined by each individual’s decade of birth, sex, race/ethnicity, and educational attainment. We assume that individuals within a specific cohort have similar career employment rate profiles. We use the 10.2 million observations to estimate these 280 career employment rate profiles. The next chart shows five of these estimated profiles for white non-Hispanic men born between 1950 and 1959 by five levels of education.

This depiction shows both the inverted U-shape for employment rate profiles and that individuals with more education tend to have higher employment rates at each age. We would expect that when the labor market is tight (slack) that average employment rates would be higher (lower) than indicated by our estimated profiles. When we estimate these 280 career employment rate profiles, we remove any of these business-cycle effects by including in the estimation a full set of year effects. We allow these business-cycle effects on employment rates to differ between men and women.

We now can assess the implications of changing population demographics on the E/P ratio. We use the 280 estimated career employment rate profiles to create a demographically adjusted E/P ratio in the following manner. For each of the 10.2 million individuals in our sample, based on their decade of birth, sex, race/ethnicity, and education, we select one of our 280 estimated career employment rate profiles. Using the worker’s age, we calculate the predicted employment rate for that individual based on their selected employment rate profile. We then calculate the weighted average of these predicted employment rates across all individuals in a given time period to generate an estimated E/P ratio for that time period. We repeat this exercise for each time period covered by our data. Finally, we seasonally adjust this estimated E/P ratio. The result is our demographically adjusted E/P ratio since it controls for changes over time both in the composition of individuals between the 280 cohorts, as well as aging of individuals within each cohort.

To overlay our demographically adjusted E/P ratio with the actual E/P ratio, we need to adopt a normalization. Recall that we eliminated business-cycle effects in the estimation by including a full set of year effects. A consequence is that there is no overall intercept for our demographically adjusted E/P ratio—only variations over time. To determine an intercept, we adopt the normalization that over the thirty-one years in our data sample any business-cycle deviations between the actual and the adjusted E/P ratios will average to zero. The next chart shows the overlay of the actual E/P ratio (in red) and our normalized, demographically adjusted E/P ratio (in blue). The demographically adjusted E/P ratio peaked in the mid-1990s and has been slowly declining since then. Importantly, from the beginning of the Great Recession to November 2013, the demographically adjusted E/P ratio has declined by 1.7 percentage points. This result indicates that although the actual E/P ratio has not changed since the end of the recession, the E/P gap defined as the difference between the two lines is actually closing due to this decline in the demographically adjusted E/P ratio. That is, a relatively constant E/P ratio since the end of the recession represents improvement in the labor market relative to an underlying demographically adjusted E/P ratio that is declining. In addition, based on our normalization, the E/P ratio was 1.6 percentage points above the demographically adjusted E/P ratio just prior to the onset of the recession. This suggests that the labor market was relatively tight prior to the recession. The same pattern shows up prior to the 1990 and 2001 recessions as well.

Adjusting for changing demographics has an important impact on the picture that emerges about the degree of the labor market recovery. The actual E/P ratio suggests that the labor market has made relatively no progress since the end of the recession in recovering from the 4.1 percentage point decline in this measure. In contrast, the gap between the demographically adjusted E/P ratio using our normalization and the actual E/P ratio is a much smaller 0.7 percentage points. Different normalizations would affect the size of this remaining gap. For example, if we assume that business-cycle effects averaged to zero just prior to the last recession (as opposed to over our full sample), then the actual E/P ratio would have been 1.4 (as opposed to 1.6) percentage points above the demographically adjusted E/P ratio at the outset of the Great Recession. In this case, the remaining gap increases from 0.7 to 0.9 percentage points. With either normalization, the basic conclusion is that the E/P gap is much smaller than it would appear making no adjustments (that is, using the horizontal blue line in our first chart as the reference point).

We have argued that the E/P ratio is a misleading indicator for the degree of the labor market recovery. However, the normalized, demographically adjusted E/P ratio is a useful additional gauge of labor market conditions. It is important to control for changing demographic factors when looking at the behavior of the E/P ratio over time. This step is particularly important today when these demographic factors are exerting downward pressure on the actual E/P rate, suggesting that the recent lack of improvement in the E/P ratio does not imply a lack of progress in the labor market. The adjusted E/P rate corroborates the basic picture from the unemployment rate that the labor market has been recovering over the past few years, but that it still has a ways to go to reach a full recovery.

Disclaimer
The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.

Samuel Kapon is a senior research analyst in the Federal Reserve Bank of New York’s Research and Statistics Group.

Joseph Tracy is an executive vice president and senior advisor to the Bank president at the Federal Reserve Bank of New York.