Another popular gauge that some have pointed to show remaining slack in the U.S. labor market is the labor force participation rate or the percent of the working-age population – defined as 16 and older – who are either employed or actively looking for work. Although the overall labor force participation rate has slowly recovered since bottoming in the second of quarter of 2020, the fourth quarter rate of 61.8% is well below the pre-crisis rate of 63.1% in the first quarter of 2020 and trails the long-run average of 62.9% from 1948 to 2021. The lagging participation rate seems to imply the Fed still has work to do to return to the labor market to pre-pandemic health. There are still 4.8 million more people not in the labor force than before the pandemic. However, if many of those people never return, due to retirement, etc., it would mean the U.S. labor market is actually closer to full employment than the labor force participation rate decline makes it appear. The Fed will have to concede U.S. labor supply has been permanently reduced and calibrate monetary policy accordingly.

Labor Force Participation Rate Has Partially Recovered

Other labor market indicators are unequivocally pointing to a tight labor market that is already at or beyond full employment. The U.S. unemployment rate is the most obvious example. The unemployment rate fell to 3.9% in December. Already under 4.0%, the U.S. unemployment rate is now somewhat below most economists' estimate of full employment and wage growth is accelerating as a result.

Annual average hourly earnings growth has accelerated sharply and averaged 4.6% over the last six months. Wage growth of this magnitude is indicative of a very tight labor market as employers are forced to raise wages to attract new employees and retain existing workers.

Moreover, the number of people who quit their job voluntarily rose to a record-high of 4.52 million in November with 1.0 million of the total in the low-wage leisure & hospitality industry. A rising number of quits suggests workers are confident in their ability to find a better job, which typically occurs during periods of labor market tightness.

The Number of People Who Quit Hit An All-Time High

Labor Market Outlook

We are of the opinion that the U.S. labor market is tighter than some of the traditional labor market indicators suggest. Although total nonfarm payrolls are over 3.5 million shy of the pre-pandemic peak and the fourth quarter 2021 labor force participation rate is 1.3 percentage points below the 63.1% recorded in the first quarter of 2020, demographics can explain a significant chunk of the shortfall. Indeed, research by the Dallas Fed suggests that over two million of the dislocated workers are not rejoining the labor force as they opted to retire amid record levels of household wealth.

We are forecasting nonfarm payrolls will climb by 3.0 million from Q4 2021 to Q4 2022 with the unemployment rate declining to 3.4% by the end of the year. This 20 basis points lower than the pre-pandemic low and the lowest U.S. unemployment rate since 1969.

The Fed's hawkish pivot that began in December and rush to raise interest rates is more likely a reflection of the evolving view of current and future labor market tightness and how that feeds through to future inflation rather than a major change in view of future supply-chain disruption. Most Fed officials still expect port backlogs and supply chain disruptions to ease before the end of the year, but a tightening labor market will keep the Fed focused on raising interest rates this year.

To learn more, check out this week’s U.S. Outlook Report.