Capital Account: Full Employment Confronts Trump, Fed with Tougher Trade-offs

In April, when the unemployment rate dropped to 4.4%, it marked the completion of a slow and joyless recovery from the Great Recession.

Eight years on, the U.S. has effectively returned to "full employment," meaning unemployment can't go sustainably lower. In reaching this milestone, the U.S. has closed one troubled chapter for the economy while opening a fresh one with tricky new trade-offs for the Federal Reserve and President Donald Trump.

For years, low interest rates and hefty government budget deficits, whatever their downsides, had one clear upside: They created more jobs in an economy that desperately needed them. That is no longer true. At full employment, those economic policy choices become harder.

The Fed and Trump administration could try to push unemployment even lower and see what happens, but history isn't encouraging. Unemployment has been this low only twice since 1990 and both times an asset bubble and inflation pressures emerged and recession soon followed.

Unemployment of 4.4% today may not mean what it did in previous decades since it has been pushed down by an exodus of working-age people from the labor force. Some economists think those workers might flood back when conditions are right, serving as a hidden reserve of labor to keep growth humming even when official unemployment seems low.

Employment as a share of the working age population is still nearly 3 percentage points below its 2007 level. But this is deceptive. The share of workers over 54 years old, and thus more likely to retire early and drop out of the labor force, has grown since then.

Economists at Goldman Sachs found that if the age structure of the population were frozen in 2007, then the employment-to-population ratio today would be much closer to its 2007 level. In other words, almost all of the job shortfall today can be blamed on demographics, not economic weakness. Most of any remaining gap probably reflects longstanding structural factors keeping some men out of work, such as disability, says Goldman.

Wage pressure, the usual sign of a tight labor market, had long been absent. Not any more. Hourly earnings growth in the last year has picked up to 2.5% from near 2% for most of the expansion. A broader measure of private sector hourly wages and benefits was up 3.9% in the first quarter from a year earlier. While disappointing compared to before 2007, this may be the new normal given sluggish worker productivity growth.

While 4.4% is below what Fed officials consider the natural unemployment rate, where price and wage pressures build, that doesn't mean inflation automatically accelerates. In fact, it's eased recently, so the natural unemployment rate may be even lower.

Yet the Fed is now playing against the clock. If employment and the labor force keep up their recent paces, unemployment will hit 3.6% by the end of 2018, which is almost certainly unsustainable in the long run.

There's no reason to expect job growth to slow of its own accord. Indeed, Mr. Trump is deeply invested in ramping it up. His economic program is premised on the notion that there are millions of hidden unemployed waiting to return to work. Tax cuts, he claims, will largely pay for themselves. "We have to prime the pump," he told The Economist magazine recently.

At almost any time between 2008 and 2014, larger budget deficits would have achieved just that by stimulating a slack economy. But at full employment, the workers needed to produce all that extra output already have jobs. Construction, for example, is being held back by shortages of skilled trades people. Priming the pump now will aggravate those shortages.

Mr. Trump's trade plans are similarly problematic. He thinks that lower trade deficits lead to stronger growth when, historically, no such relationship exists. In theory, choking off some imports and raising exports could add to output, but only if there are workers available to produce the additional goods. At full employment, they will increasingly have to be drawn from other sectors. Even manufacturers report struggling to fill many vacancies.

"Even if you manage to turn more protectionist trade policies into near-term positives for cyclical strength of the economy, it's not so sure that that's a good thing," says Jan Hatzius, Goldman's chief economist.

So in the still uncertain event Mr. Trump does slash taxes or curb imports, he may temporarily drive unemployment even lower. That would force the Fed to eventually guide unemployment back up via much higher interest rates to prevent overheating. Since World War II, Goldman notes, whenever the unemployment rate has risen a third of a percentage point, it has kept going until the economy falls into recession. That doesn't mean it will happen now; yet it's an eventuality for which neither the markets, the Fed nor Mr. Trump seem prepared.

Write to Greg Ip at greg.ip@wsj.com

(END) Dow Jones Newswires

May 17, 2017 10:55 ET (14:55 GMT)