Today CBO’s Director testified before the House Budget Committee about the agency’s projections for the federal budget and the U.S. economy over the next 10 years, which were recently published in The Budget and Economic Outlook: 2017 to 2027. Included in that report was CBO’s assessment of the labor market this past year and for the next two years.
The Labor Market in 2016
A modest increase in economic output during 2016 was enough to ensure that labor markets kept improving. Payrolls grew by 180,000 jobs per month, the labor force participation rate increased slightly to 62.8 percent, and the unemployment rate fell to 4.8 percent, down from 5.3 percent in 2015. (The labor force participation rate is the percentage of people in the civilian noninstitutionalized population who are at least 16 years old and are either working or seeking work. The unemployment rate is the percentage of the labor force that is jobless and actively seeking work.)
The primary measure that CBO uses to assess the degree of slack (that is, unused productive resources) in the labor market is the estimated shortfall between employment and potential employment. Potential employment is the number of people employed when unemployment is at its natural rate—the rate that arises from all sources except fluctuations in aggregate demand—and when labor force participation is at its potential rate. (Aggregate demand is the overall demand for goods and services in the economy.) CBO estimates that the employment shortfall shrank from 3.2 million people at the beginning of last year to 1.6 million people at the end of the year. That decline reflects an increase in the labor force participation rate relative to its potential as well as a drop in the unemployment rate.
Tightening labor markets during the past year have put upward pressure on employees’ compensation, as businesses have had to compete harder to attract workers. That rise in compensation is indicated, for example, by the employment cost index (ECI) for workers in private industry, which measures the average cost of an hour of labor, including wages, salaries, and benefits. Between the fourth quarter of 2015 and the fourth quarter of 2016, the ECI rose by an estimated 2.4 percent, up from a 1.9 percent increase in the previous year.
The Labor Market Outlook for 2017 and 2018
CBO expects slack in the labor market to disappear over the next two years, as the growth of aggregate demand increases the demand for labor, eliminating the shortfall between actual and potential employment by the end of 2018 (see the figure below). That estimate is the effect of two expected developments. First, the gap between the actual and potential rates of labor force participation is projected to narrow; second, the unemployment rate is projected to fall below its estimated natural rate in 2017 and 2018. Also, increased demand for labor and competition for workers are expected to boost the growth of hourly labor compensation over those two years.
Employment. CBO projects that nonfarm payroll employment will increase more slowly over the next few years than it has recently—by an average of about 160,000 jobs per month in the first half of 2017, 116,000 jobs per month in the second half of 2017, and 94,000 jobs per month in 2018. One reason that employment growth is projected to slow is that as the employment shortfall shrinks, fewer people without jobs will be available to enter employment. A second reason is the retirement of baby boomers—people born between 1946 and 1964—which will slow the growth of the labor force. CBO’s employment projections imply that the number of people employed, measured as a percentage of the population, will increase by about one-quarter of a percentage point—to 60.0 percent—by the end of 2017 and then decline.
Labor Force Participation. CBO expects the labor force participation rate to average 62.8 percent this year and next year (see the figure below). The rate was also 62.8 percent last year, roughly where it has stood, on average, since 2014, and 0.7 percentage points below CBO’s estimate of the potential rate. CBO projects that after 2018, the participation rate will fall and be roughly one-tenth of a percentage point below the potential rate, reflecting CBO’s estimate of the long-term relationship between the two.
Several factors have been pushing down the labor force participation rate during the past two decades and are expected to keep doing so in the future:
- Members of the baby-boom generation will continue to retire from the labor force in large numbers; this factor is the most important.
- The lingering effects of the 2007–2009 recession and ensuing weak recovery will continue to hold down participation slightly, in CBO’s view. Despite recent declines in long-term unemployment, some of the people who lost jobs in the recession left the labor force and will not return.
- Federal tax and spending policies are expected to lower participation rates slightly. In particular, under the current-law assumptions that govern its projections, CBO anticipates that people would keep responding to provisions of the Affordable Care Act by reducing the amount of labor that they are willing to supply over the next few years. The structure of the tax code, which pushes some people with rising income into higher tax brackets, would also lower participation rates.
- Long-term trends involving particular groups of people, such as a growing number of people with disabilities, are projected to push down the overall participation rate slightly.
However, the long-term factors pushing down the labor force participation rate are expected to be largely offset in 2017 and 2018 by continued improvement in hiring, as solid employment growth and rising wages draw some workers back into the labor force and keep others from leaving.
Unemployment. CBO projects that the unemployment rate will fall from 4.7 percent in the fourth quarter of 2016 to 4.5 percent by the end of 2017 and to 4.4 percent by the end of 2018, which would be about 0.3 percentage points below the agency’s estimate of the natural rate of unemployment (see the figure below). That decline in the unemployment rate reflects a projected increase in demand for labor that would reduce the number of unemployed people. However, the stronger demand for labor would also encourage people to remain in the labor force or rejoin it, making the labor force larger and thus moderating the decline in the unemployment rate. Even though the unemployment rate is expected to be relatively low during 2017, CBO anticipates that some slack will remain in the labor market, because fewer people will be participating in the labor force than would do so if the economy was operating at its potential.
CBO expects the natural rate of unemployment to be 4.7 percent in 2017 and 2018. That expectation reflects the rate’s decline in recent years—which has occurred as the composition of the workforce has shifted toward older workers, who tend to have lower unemployment rates, and away from less educated workers, who tend to have higher unemployment rates.
Labor Compensation. As slack diminishes and firms must compete harder for a shrinking pool of unemployed or underemployed workers, growth in hourly compensation will rise, in CBO’s assessment. CBO estimates that the employment cost index for workers in private industry will grow by more than 3 percent per year, on average, over the next several years, up from the 2 percent average from 2010 through 2015 (see the figure below). Other measures of compensation, such as the average hourly earnings of production and nonsupervisory workers in private industries, are similarly expected to grow more quickly than in recent years.
Joshua Montes is an analyst in CBO’s Macroeconomic Analysis Division.