By Rich Miller – Sep 8, 2013 11:00 PM CT

Source: Bloomberg

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The good news may be bad news for the Federal Reserve as it considers when to begin scaling back its stimulus.

While unemployment dropped last month to 7.3 percent, the lowest level since December 2008, the decline occurred because of contraction in the workforce, not because more people got jobs. Labor-force participation — the share of working-age people either holding a job or looking for one — stands at a 35-year low.

The reduced workforce “poses a problem for the Fed,” said Roberto Perli, a former central bank official who is now a partner at Cornerstone Macro LP in Washington. “Theunemployment rate is coming down faster than the Fed thought, but it’s not declining for the right reason.”

The jobless rate is important because Chairman Ben S. Bernanke and his colleagues have established it as the lodestar for policy. Bernanke has said he expects the Fed to complete its asset-purchase program in the middle of next year when unemployment is around 7 percent.

So long as inflation remains contained, the central bank has said it won’t even consider raising its benchmark interest rateuntil unemployment falls to 6.5 percent. The Fed cut its target for the overnight interbank rate effectively to zero in December 2008 and has held it at that record low.

A key question facing policy makers is how much of the decline in the participation rate is structural and long-lasting and how much is cyclical and temporary.

Boomers Retiring

If the drop is mainly driven by demographics — aging baby boomers retiring — then the lower unemployment rate gives a true picture of the amount of slack left in the labor market. If the contraction instead is caused by discouraged job-seekers giving up their search, then the jobless rate doesn’t reflect the true state of the market.

Both alternatives have implications for bond investors. A quicker swing from stimulus to austerity by the Fed would push up yields on Treasury securities. John Herrmann, director of U.S. rate strategy at Mitsubishi UFJ Securities USA Inc. in New York, forecasts the yield on the 10-year Treasury note will rise to 3.25 percent by the end of this year as the jobs market strengthens. It was 2.93 percent at 4 p.m. in New York on Sept. 6, according to Bloomberg Bond Trader data.

Since hitting a 26-year high of 10 percent in October 2009, the unemployment rate has fallen 2.7 percentage points, according to the Labor Department in Washington. A big portion of that decline — 1.8 points — was because of a drop in labor-force participation to 63.2 percent.

Divided Economists

Central bank economists are divided over how much of the fall in the workforce is structural and thus not likely to be reversed.

“There is disagreement within the system,” said Geoffrey Tootell, senior vice president and director of research at the Federal Reserve Bank of Boston.

A July 2013 paper by Boston Fed economists Michelle Barnes, Fabia Gumbau-Brisa and Giovanni Olivei concluded that a significant portion of the drop since the start of the last recession results from demographic and other developments that probably will persist.

“About two-thirds of the decline has been trend” due to secular forces, Olivei said. He reckons the participation rate now is about three-quarters of a percentage point below where it otherwise would be because of temporary forces stemming from the 2007-09 recession and the muted recovery since then.

His estimate contrasts with research by Julie Hotchkiss, a senior adviser at the Atlanta Fed. In a paper with Georgia State University’s Fernando Rios-Avila that was published in March, she argues that cyclical influences are all-important in explaining the shrinkage in the labor force.

Fed’s Forecast

If the labor market recovers to pre-recession levels, the participation rate over the years 2015 to 2017 will average a about third of a percentage point more than it did from 2010 through 2012, they found. That would put it at 64.5 percent.

At that level, payrolls would have to rise close to 425,000 per month for the Fed to achieve its forecast of 7 percent unemployment by the middle of next year, according to a jobs-calculationformula developed by Atlanta Fed economists.

If participation held steady at its current level, payrolls would have to increase about 142,000 a month. The average so far this year has been 180,250.

The continued contraction in the number of workers, even as the job market improves, is raising questions at the Fed about how much of the shrinkage is temporary and will be unwound, saidMichael Feroli, a former central-bank researcher who is now chief U.S. economist at JPMorgan Chase & Co. in New York.

Shifting Consensus

He said the consensus within the central bank seems to be shifting toward seeing the fall as more long-lasting and structural than cyclical.

“More and more, that seems to be the way they’re going,” he said.

The central bank’s policy-making Federal Open Market Committee will decide to begin reducing its monthly asset purchases at its next meeting on Sept. 17-18, according to economists surveyed by Bloomberg News.

Mary Daly, group vice president and associate director of research at the Federal Reserve Bank of San Francisco, said she now estimates that about 60 percent of the fall in participation since 2008 is because of structural forces, including the aging population. Previously, she had put that share at 50 percent.

More people than she expected are leaving the workforce because they’ve become permanently disabled, while fewer spouses of working Americans are rejoining.

Lower Payrolls

Even so, she anticipates many Americans will resume looking for work as the expansion proceeds — it’s just that the jobs market will need to be much stronger. Payrolls, in particular, remain 1.9 million lower than their January 2008 peak.

“This is not a sea change in how we think about this,” she said.

Daly played down the differences within the Fed on the issue. She now reckons that participation is anywhere from three-quarters of a percentage point to 1.25 points below where it would be if not for the cyclical forces at work.

Representative Kevin Brady, chairman of Congress’s Joint Economic Committee, highlighted the shrinking workforce in a Sept. 6 statement criticizing President Barack Obama’s handling of the economy.

“The labor-force participation rate fell to 63.2 percent, a level not seen since Jimmy Carter was president,” the Texas Republican said. The “failure of President Obama’s policies are becoming clearer day by day.”

Defending Obama

Jason Furman, chairman of the White House Council of Economic Advisers, defended Obama’s economic record, pointing out that private-sector payrolls have risen for 42 consecutive months.

The experience of 53-year-old Richard Freitas underscores how difficult it can be for economists to sort out what’s going on in the labor market.

Three years after he was let go from his information-technology post at Duracell Inc. in Bethel,Connecticut, Freitas said he deleted a folder on his computer desktop that held his resumes. He dropped out of the labor force in July to focus on applying for disability insurance — “stress is a silent killer,” he said — that could help him pay expenses such as rent and child support.

Freitas was employed for 34 years, half of them as an aircraft mechanic at Stratford, Connecticut-based Sikorsky Aircraft Corp. He said he hopes to resume his job search in about three to six months if he’s able to retain financial security and avoid being evicted.

When it comes to the fall in participation, “it’s very hard to say what is cycle and what is trend” the Boston Fed’s Olivei said. “Whatever study you pick, there is quite a bit of uncertainty around the estimates.”

To contact the reporter on this story: Rich Miller in Washington at rmiller28@bloomberg.net

To contact the editor responsible for this story: Chris Wellisz at cwellisz@bloomberg.net