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How will the Fed know if we've hit "full employment"?

How close is the U.S. to "full employment"? That's a crucial question for the Federal Reserve, and the answer plays a leading role in its decision about when to finally begin raising its policy interest rate. After all, the Fed's two primary mandates are to manage the economy in a way that meets its employment goals and its inflation goals. So, jobs are one of two key metrics it follows for setting monetary policy.

The country's official unemployment rate is now 5.1 percent, a level that historically has indicated an economy at or very near full employment. But this "headline" employment rate has some well-known problems, such as its failure to account for discouraged workers, underutilized workers and demographic effects. When these factors are accounted for, and when other statistics such as the prime-age employment-to-population ratio are examined, the labor market doesn't look so rosy.

Janet Yellen: No "single metric" to determine full employment 01:34

However, considerable uncertainty surrounds the true state of the labor market, so researchers at the Atlanta Fed have developed an alternative to standard labor market measures that could provide a clearer picture of where things stand.

Using the prime-age employment-to-population ratio to characterize the state of the labor market (instead of the standard employment-to-population ratio, which includes all workers) overcomes some of the problems with the unemployment rate. It reduces the distortions from demographic change due to aging, and it doesn't have the discouraged worker problem. It's an approach I've advocated in the past.

But it's not perfect, either. It can still be affected by labor supply trends. For example, if a prime-age worker voluntarily leaves the labor force, the prime-age employment-to-population ratio will fall, indicating that the economy isn't using labor resources as effectively. Thus, the labor market will appear to have deteriorated.

But in what sense is this former worker truly an idle resource? The individual has voluntarily left the labor market and has no interest in returning. This gets at the core of the problem. What we'd like to measure is how well the working-age population is being utilized. What percentage of the potential labor force could be used to produce goods and services but instead sits idle?

The Atlanta Fed has developed a new measure of labor utilization that overcomes some of the problems with the prime-age employment-to-population ratio. The researchers define the percentage of idle resources to be the percentage of the unemployed working-age population, employed part-timers who want to work full-time and those out of the labor force but wanting a job (discouraged workers). They call this measure the ZPOP, and according to it, the economy is performing a bit better that the prime-age employment-to-population ratio indicates:


However, this doesn't mean the U.S. has reached full employment. As Atlanta Fed researchers John Robertson and Ellyn Terry noted:

The headline U-3 unemployment rate is very close to its prerecession level but is thought to overstate the health of the labor market. At the same time, we think that the EPOP ratio overstates the amount of remaining labor market slack. The ZPOP ratio is in the middle; approaching its prerecession level but still with some way to go.

One final note about this and other measures of resource utilization. Full employment is defined as more than full utilization of resources. Just because a worker is employed doesn't mean he or she is doing what they're best at or employed in their most productive occupation. If an unemployed engineer takes a job waiting tables to feed the family, that worker will be defined as fully employed, but that worker's potential is hardly fully utilized.

The problem is that once a worker takes a job, he tends to get stuck there even as the economy improves. Unless there's a way to reallocate labor so that more workers are doing what they do best -- so that output will increase -- then we aren't fully and efficiently utilizing the labor force. Measuring how well workers are matched to jobs is extremely difficult, but it's a consideration worth thinking about when trying to figure out how close the economy is to its potential output.

The Fed has a difficult job. It must assess how close the U.S. is to full labor force utilization, and how that translates into inflation risk. Both steps of that process involve considerable uncertainty. The Atlanta Fed's new ZPOP measure attempts to provide additional clarity, but as the researchers acknowledge, this measure isn't perfect. In the end, the Fed will always have to make its monetary policy decisions based on incomplete information about the economy.

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