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April 27, 2018 
3 min read
Amid all the hot takes on the latest wage inflation data, it’s easy to proclaim “supply and demand still drive wages” and move on to the next topic — but to leave it at that would miss a valuable lesson about the labor market. The first quarter brought the Employment Cost Index (ECI) to a new post-recession high. Why? Yes, the decline in the unemployment rate has flattened out, suggesting that available labor supply is dwindling, and some will no doubt argue that the Fed needs to accelerate its rate hikes. Yet a more granular look at unemployment suggests that specifically long-term unemployment plays a role — and that measure suggests the Fed’s current pace is about right.
It’s true that there are many signs of tightness in the labor market – rising wages, declining teenage and minority unemployment, and a resurgence in job hopping. Still, there are some lingering signs of the labor market slack made famous by former Fed Chair Yellen. Some of these apparent stragglers actually reflect structural changes in the labor market that won’t be reversing any time soon, such as the rise in involuntary part-time work. Others suggest that more progress is still possible.
This was back in the days when a lot of people thought an unemployment rate of 6% or 6.5% might indicate full employment. Two percentage points later, we’re still debating the unemployment-inflation relationship, and yet the role of long-term unemployment still hasn’t gotten its due. A simple decomposition of unemployment by duration reveals that long-term unemployment is only now beginning to approach a more normal level.
Prior to 2008, long-term unemployment (27 weeks or longer) tracked closely with unemployment of 15-26 weeks (let’s call that “extended medium-term”), with only modest divergence in prior recessions. These two rates diverged sharply in the last recession, because in the sluggish recovery, a lot of people without jobs found themselves effectively locked out of the hiring process. They continued to search actively, but time and again, they were passed over for new entrants and re-entrants to the labor force – candidates with desirable skills fresh out of school, back from parental leave, or coming out of retirement.
The recent steeper decline in long-term unemployment indicates that employers are digging deeper into the labor supply in order to fill their positions. This is good news on two accounts. First, it’s a harbinger of faster wage growth, because it shows employers’ growing confidence that there will be sufficient customer demand to justify committing to new headcount. It also aligns with growing reports that employers are more willing to hire people with potential and give them some training, rather than hold out for a candidate with precisely the right skills and experience.
At the beginning of this year, the spread between long-term unemployment and extended medium-term finally reached 0.3% — at long last, within range of historical norms. Possibly this is a necessary but insufficient condition for wage growth: in the past 3 economic cycles, that 0.3% level has been breached about a year ahead of wages breaking into a new range (and at least 2 years before a recession). Is it a coincidence that faster wage growth has coincided with a re-normalization in long-term unemployment?
These relationships are loose, to be sure. Still, as much as this re-normalization represents progress, it suggests there may yet be pockets of slack left.
That said, given the balance of other indications of labor market tightness, firming inflation, and solid overall growth, the Fed is right not to wait this out. Real interest rates are 1% or less, and it will still take time for rate hikes to have an impact. Still, the decline in long-term unemployment is an important reminder to keep the rate hikes gradual. In the meantime, it’s good news that we are likely to see a little more progress in bringing the long-term jobless back into the fold.
