The Shadow Labor Supply and It's Impact on QE

A recent bulletin from the Federal Reserve Bank of Kansas City looks at the shadow labor supply and its impact on the unemployment rate, an issue that will ultimately impact the ultimate duration of the Federal Reserve's purchases of securities (aka quantitative easing) now that Mr. Bernanke has hinged the Fed's policies on an unemployment rate of 6.5 percent.

The authors of the bulletin, Troy Davig and Jose Mustre-del-Rio, define the shadow labor supply as the number of individuals who express an interest in working but who are not actually looking for a job.  These individuals are not technically considered "unemployed" since they are not actively seeking work.  As well, the shadow labor supply includes workers that are discouraged because they view the odds of getting a job as remote and those who are considered marginally attached to the workforce simply because they have not looked for a job in the past four weeks of the survey period.

As shown on this graph, the number of these individuals that make up the shadow labor supply rose sharply during the Great Recession and has remained at an elevated level that is the highest in nearly 20 years since the "end" of the last contraction:

Prior to the Great Recession, between 4.5 million and 5.25 million Americans made up the shadow labor force.  In July 2013, the Bureau of Labor Statistics (BLS) showed that 6.862 million Americans wanted a job but were not in the labor force, about the same level as seen in July 2012.  Please note that I am using the not seasonally adjusted data.  This is an increase of between 30.7 and 52.5 percent depending on the baseline used.

As shown on this graph, the unemployment situation in America looks far worse than the headline number if you add the total number of unemployed to the number of discouraged workers (currently standing at 988,000 in June 2013):

Rather than a headline number of 7.4 percent, the economy is actually experiencing an unemployment rate of 8.3 percent.  Even that number is still very optimistic particularly when you consider the size of the shadow labor force.

The authors of the bulletin note that the shadow labor supply could have a marked impact on the unemployment rate going forward.  Basically, if the 6.8 million Americans that want work actually start looking for work thereby reinserting themselves back into the BLS definition of the unemployed (since they are actually looking for work), by definition, the unemployment rate will rise.  If the group of Americans that want a job but are not looking for work flow back into those numbered among the technically "unemployed" at the same rate as seen shortly after the crisis of 2008 - 2009, the unemployment rate will be 0.4 percentage points higher than otherwise projected by the end of 2016.

Under another set of scenarios, the authors use the flow of workers out of the shadow labor supply to impact the labor force participation rate (defined as the percentage of working age persons in an economy that are employed and unemployed but looking for a job).   Under the scenarios used, the labor force participation rate is allowed to fluctuate between 62 percent and 64.5 percent.  The higher rate means that more of the shadow labor force has entered the job market and are now statistically classified as unemployed.  Under the scenario where more shadow laborers enter the job market and push the labor force participation rate up to 64.5 percent, a not unrealistic situation given that the current rate is 63.4 percent, the unemployment rate will be 1 percentage point higher by the end of 2016 that it would be under the scenario where very few shadow laborers enter the job market and the labor force participation rate is only 62 percent.  That is a significant increase in the headline unemployment rate.

The bottom line of this analysis suggests that much of the Fed's future policies hinge on the decisions made by millions of Americans who make up the shadow labor force.  If they decide to re-enter the jobs market, the unemployment rate will be pushed up from its current artificially low level, making it difficult for the next head of the Fed to end QE anytime soon and allow interest rates float upwards from their current artificially low levels.  It's all in the hands of Americans who are not technically unemployed but who are clearly not working and would prefer to.