James W. Paulsen, Ph.D.

Perspective

Economic and Market

December 4, 2014

Bringing you national and global economic trends for more than 30 years

Unemployment Rate Falling Much Faster Than Expected

The current recovery has been characterized by much
slower growth compared to most post-war recoveries.
Despite modest economic growth, however, the unemployment rate has declined steadily in recent years.
Indeed, in the last three years, the unemployment rate
has fallen slightly more than 1% annually even though
real GDP growth has averaged only 2.47% and annual
average job growth has been even less at 1.78%. Moreover, despite far more tepid economic growth in this
recovery, the unemployment rate during its first five
years has fallen nearly as fast and as much as it did in the
early 1980s recovery (the only other post-war recovery
which began from an unemployment rate above 10%).
How, when the pace of job creation has been widely
perceived as insufficient to reduce unemployment, has
the unemployment rate fallen so quickly? Many have
postulated the improvement is probably temporary and
due primarily to a large segment of discouraged workers remaining outside of the labor force since the last
recession. However, this argument is becoming less convincing as the unemployment rate continues its decline
back near full employment with little evidence of a rush
of previously discouraged workers returning to the job
market. Our own view is the rapidly declining unemployment rate in the face of continued modest economic
growth is mainly due to aging demographics and a very
slow growing working age population (i.e., slow growing
labor supply).
The most important question for investors, however,
is whether the unemployment rate continues its rapid
decline. With the unemployment rate now below 6%,
further brisk declines (e.g., if it continues at its recent
pace of falling at about 1% a year), with or without
evidence of accelerating wage inflation, would likely become increasingly problematic for the Federal Reserve
and on Wall Street.

How weak growth = Rapid declines in the

unemployment rate?

Chart 1 shows how sluggish the pace of job creation has

been in this recovery compared to post-war history. In
the last few years, annual job growth has been between
about 1.5% to 2%, slightly less than the weak employment growth experienced in the last recovery and far
weaker than the 2.5% to 4+% annual job gains experienced in many past recoveries.
Chart 1: U.S. nonfarm payroll employment
Annual growth

Economic and Market Perspective

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Chart 2, however, illustrates how even weaker than normal

job growth has been sufficient to keep the unemployment
rate falling at a healthy clip. The solid line in this chart shows
the annual growth in the U.S. working age population (i.e.,
total civilian non-institutional population between the ages of
20 and 65). From the mid-1980s until the last recession, the
working age population grew slightly more than 1% annually
and during the 1970s, the U.S. labor supply often grew about
2% annually. By contrast, in the last year, the labor supply has
grown at only 0.5%, one-half its pace between 1985 and 2005
and one-quarter as fast as in the 1970s! Since aging demographics has slowed growth in the supply of labor to less than
0.5% annually, even very tepid job gains can lower the unemployment rate. For example, in the last year, job growth has
been slightly less than 2%. In the 1970s, when the labor supply
often surpassed 2% growth, such job creation would have
resulted in rising unemployment. Conversely, today, 2% job
creation has produced an almost 1.5% drop in the unemployment rate because the working age population has only risen
by about 0.5%!
Chart 2: U.S. working age population* versus labor force
Annual growth
U.S. working age population growth (Solid)
U.S. labor force growth (Dotted)
*Working age population growth based on all civilian noninstitutionalized 20- to 65-year-olds.

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Many, including the Fed, have argued there is considerable

slack in the job market. Will the U.S. labor force soon jump
significantly as discouraged workers finally return? Chart 2
shows that labor force growth has historically been anchored
by and oscillates about the growth rate of the working age
population. So although labor force growth could temporarily
rise above the pace of the working age population growth, it
is not likely to sustain at a significant faster growth rate. With
the working age population only growing about 0.5%, even if
the labor force were to grow 1% faster, the unemployment
rate would still decline by 0.5% a year given the current rate
of job creation.
Since the job market has recently improved, labor force
growth will likely accelerate some as discouraged workers
return to the job market. However, since the working age
population growth is so slow, labor force growth is not
likely to sustain much above 1%. Moreover, recently, both
the economy and the job market appear to be improving.
Consequently, even if labor force growth does rise to about
1% (i.e., perhaps about 0.5% above working age population
growth), job growth will also accelerate mildly to about 2.5%.
The net result (a 2.5% job gain combined with a 1% rise in
the labor force) is still another rapid decline of about 1.5% in
the unemployment rate during next year.
Certainly this scenario does not have to happen. As shown in
Chart 2, labor force growth has diverged from working age
population growth by wide margins at various times. Perhaps,
in the next couple years, the labor force will grow much
faster than the working age population helping to lessen
the decline in the unemployment rate. However, labor force
growth has seldom sustained at a pace that far removed
from the growth rate of the underlying population. Therefore,
we suspect labor force growth will not likely sustain much
above 1%. With job creation already at 2% and appearing likely to rise even more in the coming year, the unemployment
rate may continue to decline rapidly in 2015.

Economic and Market Perspective

3

Labor slack disappearing quickly

Chart 3 illustrates the pace of excess job creation. That

is, annual job growth less annual growth in the working age
population. Even though annual job growth has been subpar
in this recovery, the pace of excess job creation (currently
at about 1.5%) does not look that abnormal compared to
historical norms.
Chart 3: Excess annual job creation
Annual growth in jobs creation less annual growth in working
age population

Chart 4 overlays the pace of excess job creation with annual

changes in the unemployment rate. As expected, changes in
the unemployment rate are closely related to the pace of
job creation relative to the growth in the labor supply (i.e.,
the pace job creation relative to the growth in the working
age population). In the last year, excess job creation has risen
by about 1.5% and the unemployment rate has declined by a
similar amount. Impressively, the pace of excess job creation
has not been this strong since the late 1990s, nor has the
unemployment rate declined this fast since the mid-1980s!
Job market slack seems to be diminishing far faster than
most appreciate.
Chart 4: Excess annual job creation versus annual change in
unemployment rate
Left scaleExcess annual job creation, Annual job growth less annual
growth in working age population (Solid)
Right scaleAnnual change in the U.S. unemployment rate, Inverted
scale (Dotted)

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Economic and Market Perspective

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Summary and implications?

Perhaps the rapidly declining unemployment rate will soon

reveal itself through rising wage inflation. This would force the
Fed to accelerate its exit strategy and cause bond vigilantes to
reprice long-term bonds. However, even if wage inflation does
not accelerate, continued rapid declines in the unemployment
rate may soon intensify pressures on the Fed and increase
anxieties in the bond market.
With job creation rising about 2% a year while the labor
supply is rising only about 0.5%, the unemployment rate is set
to continue falling by about 1.5% annually. Imagine seeing the
unemployment rate in the low 4% range this time next year.
As Chart 5 illustrates, this would represent one of the lowest
unemployment rates in the last 50 years! Even if labor force
growth accelerates to about 1% and the unemployment rate
falls by only 1% in the next year, it would still decline below
5%. Whether wage inflation rises or not, will the Fed still be
debating whether it should lift short-term interest rates from
zero? If the unemployment rate surprisingly declines below
5%, will investors still be comfortable buying 10-year Treasury
bonds with a 2.3% yield?

Could both the Fed and investors be misinterpreting signals from the job market? Compared to historic norms, the
current weak pace of job growth and lack of wage inflation
implies weak demand creating a sense that interest rates can
remain lower for longer. But what if aging U.S. demographics
has caused the job market to be more dominated by supply-side growth? What if it isnt the traditional spike in wages
(demand-side indicator) which spooks the bond market but
rather a shockingly large decline in the unemployment rate
(supply-side indicator)? Most are waiting on evidence of
faster demand before adjusting policies or altering investment
positions. Perhaps, however, it is an underappreciated change
in supply which should be feared. Even with relatively modest
economic growth, could a very slow growing labor supply
produce a labor shortage problem as the unemployment
rate dips below 5%?
Just something to ponder on yet another payroll Friday.

Chart 5: U.S. unemployment rate

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Written by James W. Paulsen, Ph.D. 612.667.5489 | For distribution changes call 415.222.1706 | www.wellscap.com | 2014 Wells Capital Management