Asset management

15 July 2013

Economist Insights Underemployed and understated

The US unemployment rate has been falling but the news is not as good as it appears. The unemployment rate only considers those who are actively looking for work so it does not capture those who have become discouraged and given up looking. The summary unemployment rate also obscures a lot of differences in the detail, such as differences between age groups. The Federal Reserve knows that the labour market is far more complicated than just the unemployment rate and has given the market a reminder of this so do not expect rates to rise sooner than the Fed has indicated. Joshua McCallum Senior Fixed Income Economist UBS Global Asset Management joshua.mccallum@ubs.com

Gianluca Moretti Fixed Income Economist UBS Global Asset Management gianluca.moretti@ubs.com

The financial crisis created the worst unemployment situation in the US for three decades, but since then the unemployment rate has been falling. Unfortunately, the news is not as good as it appears. As Chairman Ben Bernanke of the Federal Reserve stated last week: the unemployment rate probably understates the weakness of the labor market. For many Americans, it is a situation of congratulations, you are no longer unemployed; but unfortunately you dont have a job. The confusion is one of definition. The unemployment rate only considers those who are actively looking for work. Such a measure is useful for economists because it excludes those who are not looking for a job at all (students, the retired, disabled who are unable to work, and those who choose to stay at home), and therefore it is good at measuring pressures on wages in the market. However, when the economy has been as bad as it is for so long, many people will become discouraged and give up looking. Others may not enter the labour market at all. The unemployment rate will not capture these people who are outside the labour force because they are not active participants and hence will not affect wages. Pick a person at random on the street in the US, and the probability that they have a job will be the same as it was three years ago, despite the improvement in the unemployment rate (see chart 1). The fall in the participation rate (all those people not looking for jobs any more) has flattered the headline unemployment rate. This is the wrong type of improvement, and Chairman Bernanke knows it. The drop in the participation rate is unprecedented in both size and speed, so this cannot be blamed on the recession. The participation rate was on an upward trajectory from the 1960s

onwards as women joined the labour force, broadly levelled out from the 1990s to early 2000s and then started to fall. Up to half of the drop in participation rate may have come from demographics as the population is aging and people move into age groups that usually have lower participation rates, but that still leaves much of the divergence to explain.
Chart 1: Gainful unemployment US unemployment rate and employment to population ratio (%) 11 10 9 8 7 6 5 4 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 65 64 63 62 61 60 59 58

Unemployment rate (lhs)

Source: Bureau of Labor Statistics

Employment to population ratio (rhs)

Break things down into a bit more detail, and there are some interesting observations. As is the case in Europe now and in past recessions around the world, the biggest losers from the recession have been the young. The increase in the unemployment rate during the crisis for those aged 16-24 was approximately double that of older cohorts (see chart 2), and the fall in unemployment since then has been proportionately less. The employment to population ratio also fell by more for

this age group than any other, which can only be explained in part by more people staying in education (rather than leave without any job prospects). One of the most striking features has been the performance of those aged over 55. This pre-retirement and retired cohort actually has a higher proportion of people employed than before the crisis, even though their unemployment rate has risen almost as much as their slightly younger counterparts. The participation rate has actually risen for this group: so they gained more jobs than they lost, but even more of them are actually looking for work than before. This may have a lot to do with the value of their pension pots: many people close to retirement age may have been planning imminent retirement, but the crisis slashed the value of their home and their equity investments. Finding themselves with insufficient funds to retire, many will have remained in their jobs wherever possible.
Chart 2: Divided and asymmetric Change in the US employment to population ratio and the unemployment rate by age, gender, race and educational qualifications. Changes show from best outcome (pre-crisis) to worst outcome (peak of crisis), and then from worst outcome to most recent reading (June 2013). Employment to population Total 16-24 25-34 35-44 45-54 55+ Male Female Black Hispanic Asian White No high school High school Further education College -10 -5 Best to worst 0 Worst to now 0 5 10 Unemployment rate

number of jobs the unemployment rate would just keep rising as the population grew.) However, during a recession when firms are reluctant to hire other than to replace workers that have left, workers who already have jobs are at an advantage over those who do not. This creates a transitional impact; the young will really only benefit when the recovery finally takes off. The recession has also been harsher on American men than women, though much of this can likely be explained by the industry-bias of the genders. There were disproportionately more men working in construction and manufacturing, both of which were especially badly hit. There are more women employed in services, and in particular healthcare, which did not suffer as much during the downturn. There is a similar story when it comes to ethnicity. People of Black & Caribbean or Hispanic origin (as defined by the Bureau of Labor Statistics) suffered far more than those of Asian or White background. Once again, this really a story about another factor: education. Far fewer of those from Black & Caribbean or Hispanic backgrounds have benefited from further education, and the recession has been particularly bad for those without qualifications. The rate of unemployment for these groups was much higher to start with. So college may be expensive in the US, but it clearly brings employment benefits. While it is useful to have summary statistics like the unemployment rate to quickly describe the economy, relying too much on these numbers means that you miss a lot of the detail. When it set its thresholds for raising interest rates, the Federal Reserve knew full well that the labour market is far more complicated than just the unemployment rate. For the sake of simplifying communication the Fed headlined the unemployment rate because it is familiar to everyone, but warned that it would be looking at other statistics as well. The market has been focusing on the steady improvement in the unemployment rate, but Chairman Bernanke looks at the employment to population ratio as well and he knows that the improving unemployment rate is largely illusion: your economy is not getting stronger when job-seekers are giving up. Chairman Bernanke has also said that he believes that much of the decline in the participation rate is cyclical: in short, when the economy gets better people will start looking for jobs. If he is right, then this means that the economy will have to generate even more jobs in order to absorb these people returning to the labour force. That would require a very strong recovery indeed, so no wonder Chairman Bernanke felt that it might have been time to warn the market that their reaction to the ending of tapering was overstated. He even warned that it may well be some time after we hit 6.5% before rates reach any significant level so it looks like the Fed target itself may be overstated as well.

Source: Bureau of Labor Statistics, UBS Global Asset Management

The decision to remain in jobs can have a knock on effect on younger cohorts. When a worker postpones retirement there is no vacancy created. Like all good economists, we know full well that the lump sum of labour fallacy is a fallacy there is not a limited number of jobs around so that old people working may keep younger people unemployed. (If there was a limited

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