The Federal Reserve’s hopes for a “soft landing” rest on a rarely occurring phenomenon: Unemployment will rise not because workers lose their jobs, but because more people without jobs start looking for work.
Typically, the unemployment rate goes up because a slowdown in the economy prompts a wave of layoffs. That hurts household spending, kicking off a dynamic that can feed on itself and plunge the economy into recession.
This time around, many forecasters expect the labor force participation rate to rise as people who quit working during the pandemic return to the job market, just as employers slow hiring in the face of higher interest rates.
If that were to happen, it might put downward pressure on incomes and spending without causing a severe downturn—the very definition of a soft landing.
Such a scenario would represent a break from past labor market patterns and mark yet another unusual legacy of a once-in-a-century pandemic for the economy. And it could give the U.S. central bank, which is rapidly hiking rates to curb decades-high inflation, license to keep them higher for longer if it plays out.
“The norm is for the Fed to push the economy into recession, you get layoffs, and that puts upward pressure on the unemployment rate,” said Jonathan Millar, a senior economist at Barclays in New York.
The narrow path to a soft landing “really depends on getting it perfect: being able to sidestep a decline in actual employment and to restore equilibrium in the labor markets by just threading the needle,” he said.
The U.S. unemployment rate—which includes those who have lost their jobs and are seeking new ones, as well as those who may have left the labor force for various reasons and are now looking for work again—ticked down to 3.5% in July, matching the pre-pandemic low. But the participation rate—which includes both the employed and job-seekers—at 62.1%, is still more than a percentage point below its February 2020 level.
Part of the gap can be accounted for by population aging. Many also retired earlier than planned at the beginning of the pandemic and are probably unlikely to return to work.
But participation among younger workers hasn’t recovered either. The rate for people between the ages of 25 and 54—those of “prime working age”—is 82.4%, down from 83.1% before COVID. The rate for those who are 16 to 24 is 55.2%, versus 57% pre-pandemic.
Economists at around half of the 25 dealer banks that trade with the Fed currently expect the U.S. to avoid a recession over the next year or two.
Many see unemployment rising nonetheless, and the assumption that a substantial amount of that increase will be accounted for by rising participation is critical to the no-recession call.
Barclays economists, for example, see the unemployment rate rising to 4.2% by the end of next year as more Americans start looking for work again in the face of a slowing economy.
That view is shared by economists at Bank of Montreal, who see unemployment rising as high as 4.6% in 2023, even as the economy skirts an outright recession. Labor force participation, they say, will rise to 62.9%—accounting for roughly half of the increase in the jobless rate.
“There’s still that legacy of people who are not in the labor force now that were either working before or looking for work before, and aren’t now because of the pandemic,” said Michael Gregory, deputy chief economist at Bank of Montreal in Toronto.
Fed officials have been waiting for participation to normalize and have often cited its failure to do so as a contributing factor behind the highest inflation in almost 40 years.
“We have been disappointed that labor force participation really hasn’t moved up since January. That may be related to yet another big wave of COVID,” Chair Jerome Powell said on July 27. “So, we’re not seeing much in the way of labor supply.”
That’s part of the reason why the Fed has raised rates quickly this year to curb demand. Officials see unemployment rising by about half a percentage point in the coming years without triggering a full-blown recession, according to their projections in June.
In that scenario, the Fed brings labor demand down somewhat in the near term, while the supply steadily normalizes over time.
But there’s a risk in viewing the two as independent of each other.
The 2008-09 recession kicked off a long decline in the labor force participation rate, which many economists and policy makers wrote off as permanent damage.
In the later years of what became the longest expansion on record, participation began rising again as a strong economy drew people who hadn’t been searching for work into employment.
Strong demand eventually induced more supply. But today, the soft-landing forecast hinges on supply increasing despite weaker demand.
Robert Shimer, an economics professor at the University of Chicago, sees that as unlikely.
“Historically, whenever unemployment has risen by any substantial amount, it’s been because of a decrease in employment, not because of an increase in labor force participation,” he said.
Those in the soft-landing camp see more factors than just the receding pandemic risk drawing people back into the job hunt. One is the promise of higher pay, with wage growth running hot. There’s also inflation.
On the other hand, there’s the impact of long COVID to consider. An Aug. 24 report by Katie Bach, a senior fellow at the Brookings Institution, estimated that anywhere from 2 million to 4 million Americans are out of work due to ongoing side effects, and suggested that number may grow over time if policy makers don’t take action to address the problem.
Economists at the banks that forecast a U.S. recession—like Aneta Markowska, the chief U.S. financial economist at Jefferies in New York — don’t see much scope for additional increases in participation.
That’s part of the reason why many of them see the Fed ultimately tightening more than investors anticipate: Policy makers may feel they have to bring labor demand down further if they don’t see labor supply increasing.
“You can push the participation rate up a little bit further, but there isn’t a huge amount of upside,” Markowska said. “There’s probably three to six more months of that. And then you’re just going to run out of people.”