We are struggling to understand a major surprise. Despite the recent improvements in job prospects, the percentage of the population either working or looking for work--that is the labor force participation rate--has not yet risen from its recessionary lows. Apparently, the demand for workers has been strong enough to allow many of those actively looking for jobs to find them but not strong enough to pull people back into the labor force who may have dropped out--perhaps for early retirement or additional schooling...The unusual behavior of labor force participation will present a challenge to policymakers.

As the economy continues to expand, the [labor] participation rate will increase, providing some additional buffer against the kind of shortages and bottlenecks often associated with rising inflation. ...This means that there is somewhat more slack in the labor market than the unemployment rate suggests—but not much more. Combined with the moderate slack in other sectors of the economy, this suggests that the current level of output is only modestly below the level of potential output.

The participation rate has fallen 1.5 percentage points over the last five years. If all of these people instead had been looking for a job, the unemployment rate would be over 7 percent. Although this is an important consideration, this calculation most likely exaggerates the amount of slack in the labor market. The drop in the participation rate may well have been from an unsustainable level...We don't believe that the official unemployment rate understates the amount of slack in the labor market by a large margin.

The pace of hiring also strengthened toward the end of last year, following a summertime lull, and I expect healthy employment gains in the coming quarters, albeit with possibly large month-to-month variations. Despite the growth in employment, however, the unemployment rate should decline relatively slowly, as a strengthening job market attracts people back into the labor force...

Evidence that the labor market is not yet at its potential includes subdued wage growth, the failure thus far of labor participation rates to increase from cyclical lows, the relatively large number of people who say they are working part-time for economic reasons, and the impression gleaned from surveys and anecdotes that the supply of potential employees in most occupations remains plentiful.

I believe that, as the baby boom generation begins to retire in a few years, it will become increasingly important for the nation to boost resources available in the future through greater national saving and enhanced incentives for participation in the labor force. The tax system has the potential to contribute importantly to those goals, and, at a minimum, tax reform should not hinder the achievement of those objectives.

If [the recent decline in labor force participation] is cyclical, and labor force participation does begin to rise, this will mean more downward pressure on inflation. If it’s not—that is, if participation does not rise or continues to fall—this will mean the remaining slack in the economy will diminish faster, creating upward pressure on inflation sooner.

In the labor market, the behavior of compensation in recent years has been consistent with standard models of wage dynamics incorporating a natural rate still somewhat below the current unemployment rate. Moreover, one of the surprising developments of the current cycle has been the extent of the decline in labor-force participation. Many analysts have adopted the working hypothesis that this decline reflects a type of "discouraged worker" effect, albeit one that is not captured in the standard statistical series attempting to measure that phenomenon. Presumably, many of the people who exited the workforce in the face of poor employment prospects now stand ready to resume competing for jobs as the market improves. If that is correct, then the current level of the unemployment rate relative to estimates of the natural rate, may, if anything, understate the availability of labor resources.