The droves of Americans who have abandoned hope of finding a job should make the Federal Reserve hesitant to remove its support for the economy, according to a study that makes a bold argument for a sustained easy monetary policy.
The findings of the study were the buzz of a high-profile conference at the Boston Federal Reserve Bank last week on how best to return employment to pre-recession levels.
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The share of working-age Americans who either have a job or are looking for work has fallen to its lowest in 34 years.
For Fed policymakers, that's a sharp reminder that the labor market remains ill despite a gradual decline in the unemployment rate since the Great Recession ended in 2009. Indeed, the dropouts are the main reason the jobless rate has declined.
This depressed "participation rate" - and the fact that it takes longer than other labor market indicators such as unemployment to recover from deep recessions - should probably get more attention as the central bank weighs when to withdraw its monetary stimulus, the study suggests.
Authors Christopher Erceg and Andrew Levin, both officials of the Fed now doing research at the International Monetary Fund, argue the central bank should aim not just for full employment with a jobless rate between 5 percent to 6 percent. Instead, it should use its powers to drive unemployment even lower to draw people back into the workforce.
The jobless rate stood at 7.6 percent in March.
"A policy of allowing the unemployment rate to overshoot is consistent with a much faster economic recovery," Erceg, an IMF research fellow, told the conference on Friday.
This very dovish idea could amplify the notion gaining traction, from the United States to Europe to Japan, that central banks should pull out all the stops to spur growth even if it means tolerating a bit more inflation.
At the conference, Lars Svensson, a deputy governor at Sweden's central bank, and Bank of England policymaker David Miles called the work important and requested more detail.
At the Fed, officials will soon have to decide how much the depressed participation rate will figure into their decision on when to wind down asset purchases and, later, to finally raise interest rates.
They have held rates near zero since December 2008 and are currently purchasing $85 billion in bonds per month in a further effort to keep borrowing costs low and spur stronger growth.
"The paper did a nice job highlighting that we need to look at a wide variety of labor market indicators," Boston Fed President Eric Rosengren said in an interview.
In March alone the labor force shrank by 496,000 people, the vast majority of them too young to retire. That depressed the participation rate to 63.3 percent, a level last seen in 1979, and led the unemployment rate lower.
"That doesn't indicate stronger labor markets," Rosengren said.
To be sure, labor force participation began a gradual decline in 2000 as baby boomers started to retire. But it shot lower when the economy fell into recession in 2007 and remains there thanks to a 2 percentage point drop in the participation of adults below the retirement age.
Erceg and Levin suggest this cyclical shortfall can be reversed by monetary policy, but they warn it will take time.
The worry is that the economy will improve and monetary policy will tighten, leaving behind millions of Americans.
"How do we draw those people back into the labor market?" asked Levin, who until last year assisted Fed Chairman Ben Bernanke and Vice Chair Janet Yellen on communicating policy strategy. "The possibility that having a target (for unemployment) that is temporarily below the (natural rate of unemployment) may be the right policy prescription."
Fed officials estimate the so-called natural rate, which serves as their long-term target, is around 5.6 percent.
Brandeis University finance professor Catherine Mann warned that pursuit of the Levin-Erceg strategy could lead the central bank to overlook the risk its easy policies could fuel asset price bubbles.
"The recipe is for more QE but this strategy ignores the building financial disruptions of the policy," she said.
More centrally, in the view of former European Central Bank policymaker Athanasios Orphanides, is the risk Fed hubris unleashes the inflation genie.
"The ... challenge at present is not to let over-confidence about how low monetary policy can guide the rate of unemployment lead to a repetition of the second-greatest policy error of the 20th Century, and create inflation," he said.
(Reporting by Jonathan Spicer; Editing by Tim Ahmann and James Dalgleish)