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How the U.S. labor market may shape the Fed’s inflation path

Labor force participation refers to the percentage of the population who are either employed or actively seeking employment. Overall, labor force participation has declined in the U.S. over the past several decades. Labor force participation for men has been steadily declining since the 1960s. However, the staggering number of women joining the workforce has allowed labor force participation to increase over the years. Labor force participation peaked at 67.3% in 2000, when women’s participation also peaked, and steadily declined until 2015, when higher real wages incentivized workers to join the workforce and brought labor force participation up slightly (Aleman, 2023). The COVID-19 pan­demic caused a significant drop in labor force participation; we are still 0.8% lower than what it was pre-pandemic (Aleman, 2023), so where did all these people go?

There are many hypotheses surrounding the whereabouts of the missing workers, and it’s unlikely that economists will have a more precise answer for years to come. However, we believe that most of these missing workers are a combination of early retirees, individuals who passed away from COVID-19, those with long COVID, a reduced number of immigrant visas, men/women working from home during the pandemic who resigned and left the workforce once asked to go back to the office, as well as workers whose opportunity cost to return to work out­paced the monetary benefits.

Although a federal funds rate of 4.75% to 5.00% is not very high historically, it is very high compared to what markets and inves­tors have seen over the last several decades. One of the biggest problem today is that economic actors (i.e., individuals, busi­nesses, the external sector as well as the U.S. government) are trying to adjust to these new levels of interest rates. We believe the way in which these economic actors adjust to higher interest rates will determine the economy’s path forward in 2023.

Early Retirees: The stock market rally in 2021 is likely to have boosted retirement savings for many Americans at and nearing retirement age. This sudden and unexpected boost in wealth has probably allowed many to weigh their options and consider leaving the workforce early. Some people, especially those with pre-existing medical conditions, may have had health concerns about returning to workplaces and catching the virus. On the other hand, others might have just opted to downsize and move to a location with a lower cost of living rather than spending additional years accumulating wealth.

Long COVID: In addition to those who passed away from COVID-19, there are many estimates of how many people are suffering from long COVID and are unable to work. We have seen estimates of this number at between one and five million Americans. How­ever large or small this number is, it is clear that long COVID may be a contributor to today’s still low labor force participation rate.

Immigration: The U.S. has issued well over eight million visas yearly between 2012 and 2018. However, the COVID-19 pandemic caused a significant decline in immigrants legally able to work in the U.S. Overall, in the last three calendar years combined, there have been between eight and 10 million fewer legal immigrants added to the workforce.

Opportunity cost: For those who were able to work remotely, returning to an in-person job can be costly, especially for families with young children, older parents, or those in other circum­stances where a worker’s presence at home would be beneficial.

What is the importance of the labor force for monetary policy?

A study by economists at the Federal Reserve Bank of Chicago in 2014 concluded that “the results from our models suggest that there may indeed be greater slack in the labor market than is sig­naled by the unemployment rate.” The importance of this finding at the time was that “the existence of such extra slack might imply that it would be appropriate for monetary policy to remain highly accommodative for longer than would otherwise be the case.” In fact, many believe that there was a larger labor slack during the pre-COVID-19 pandemic period kept the Fed highly dovish even in the face of very low rates of unemployment, as this greater slack in the labor market reduced the possibility of experiencing increases in wages and salaries that would have jeopardized the pursuit of the Fed’s inflation target of 2.0%.

Today, the question of whether there is more or less slack in the U.S. labor market is one of the most consequential questions for monetary policy going forward, as it will determine how high and for how long the Fed is expected to remain hawkish/dovish on the inflation front.

The Fed has allowed the rate of inflation to overshoot its 2% target for two years and they need to push this ‘over the longer-run’ average down as fast as possible. One of the factors potentially threatening this strategy is the strong U.S. labor market. For this reason, we expect the Fed’s stance to remain hawkish for longer, rather than return to a more accommoda­tive stance in the short to medium term. Although many of the reasons for individuals not coming back into the labor force are almost impossible for policymakers to affect, the immigra­tion issue is one of those partial solutions that could help increase the labor force participation rate and is in the purview of the political establishment to achieve.


Aleman, Eugenio J., and Giampiero Fuentes. “How the U.S. Labor Market May Shape the Fed’s Inflation Path.” Raymond James, 10 Apr. 2023.

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