Are the long-term unemployed just doomed today or doomed forever?
That's the question people are really asking when they ask if labor markets are starting to get "tight." Now, it's hard to believe that this is even a debate when unemployment is still at 6.7 percent and core inflation is just 1.1 percent. But it is. The new inflation hawks argue that these headline numbers overstate how much slack is left in the economy. That the labor force is smaller than it sounds, because firms won't even consider hiring the long-term unemployed. That our productive capacity is lower than it sounds, because we haven't invested in new factories for too long. And that wages and prices will start rising as companies pay more for the workers and work that they want.
In other words, they think that the financial crisis has made us permanently poorer. That the economy can't grow as fast as it used to, so inflation will pick up sooner than it used to—and we need to get ready to raise rates. (Notice how that's always the answer no matter the question).
There are only two problems with this story: There's not much evidence for it, and we should ignore it even if there is. It's pretty simple. If tighter labor markets were causing wage inflation, they'd have caused wage inflation. But they haven't, not really. Now, it's true that average hourly earnings ticked up in February, but, as Paul Krugman points out, that was probably a weather-related blip. All the snow kept 6.8 million people from working full-time like they normally do, and, historically-speaking, that tends to affect hourly workers more than salaried ones. So higher-paid people probably made up a bigger share of the workforce last month—and voilà, it looked like wages rose. But that was just statistical noise, and if you look at the bigger picture, wage growth is still far below its pre-Lehman levels.
Okay, but what about evidence that wages will soon start rising even if they aren't now? Evan Soltas points out that more people are quitting their jobs, which only happens when they think they can get another one—and a raise. "The large number of quitters," he says, "only makes sense if the long-term unemployed and labor-force dropouts aren't competing with them."
Well, maybe not. I looked at the relationship between the long-term unemployment rate and the quit rate going back to December 2000, when the data begins. It's clearly "shifted out" since the Great Recession hit, but not much if it's a logarithmic relationship. This last point is key. If there really is less slack than we think, we'd expect there to be more quits today than the pre-2008 trend predicts. But there aren't. We're exactly where that trend says we should be.
In other words, there's at least as much slack as we'd expect in a world with 6.7 percent unemployment and 2.3 percent long-term unemployment. Which is to say, quite a bit. The question then is if there's actually more slack—and what the Fed will do if there is.
This is where the guesswork really begins. Nobody knows how many of the people who stopped looking for work the past five years will start looking again now. Some of them retired, and won't return. But others just went back to school or temporarily gave up looking because things seemed so hopeless—and will come back sooner or later. You can see what this might mean in the chart below. It compares the percent of people who weren't looking for work but still found a job with the unemployment rate. There isn't the strongest relationship—an R-squared of 0.69—but there still is one. In general, the lower the unemployment rate, the more people outside the labor force find work. A strong jobs market sucks people in.
So maybe these "shadow unemployed" will return as the economy returns to normalcy. And maybe that'll keep wages from rising too much. But maybe not. Maybe the new inflation hawks are right, and companies will prefer to pay a premium for the already-employed rather than taking a chance on somebody else. Should that change the Fed's thinking?
No. Because we don't know what will happen, and it's worth risking a little inflation to try to get people back to work. There's a chance that the returning labor force dropouts will keep wages from rising too much, and we'll all live happily ever after. But there won't be any chance of them returning if the Fed prematurely raises, or says it might raise, rates. So even though wages are, as San Francisco Fed President John Williams points out, a lagging indicator, the Fed should wait till they're back to normal to tighten. That's because the economy still isn't normal. It's left too many people behind. And, as a recent IMF paper argues, that justifies what seems like an overly aggressive response, lest they be left behind forever.
The long-term unemployed aren't doomed—unless we decide that it isn't worth risking three percent to save them.