Economy’s Fate Might Hinge on Question of ‘Full Employment’

Whether the U.S. is there is a wonkish debate mainly being hashed out at the Federal Reserve as it determines how quickly to raise interest rates. But its resolution will help shape the U.S. economy—and Americans’ ability to get jobs, command higher wages and improve living standards in the years ahead.

The Fed under Chairman Jerome Powell has resisted precisely defining full employment, sometimes called maximum employment. But one guidepost comes from its projections of where the unemployment rate will settle in the long run. In December, most officials thought that was around 4%.

By that measure, the U.S. is already there. In December, the unemployment rate fell to 3.9%, down from 6.7% a year earlier, the Labor Department said last week.

Meanwhile, employers added just 199,000 jobs last month, less than half the average monthly gain for all of 2021. Hourly wages rose 4.7% in December from a year earlier, far higher than the 2.9% gain in 2019. Workers are quitting at the highest rate on record, often for higher pay.

On the surface, that suggests that there simply aren’t many workers left to hire and that the recovery has run its course. With inflation at a near-40-year high of 7% in December, conditions seem to meet the textbook definition of full employment.

In fact, Sung Won Sohn, an economist at Loyola Marymount University, said the U.S. is above full employment. He points to the high inflation rate, which he said is being driven by rising wages. “And I don’t think we have seen the light at the end of the tunnel yet,” Mr. Sohn said.

The debate hinges largely on the size of the labor force, which was 1.4% smaller, or 2.9 million people, in December than before the pandemic. Are those people gone for good, or will some come off the sidelines and apply for one of the many job openings?

Through August, roughly 2.4 million workers retired early because of the pandemic, according to research from the Federal Reserve Bank of St. Louis. Most are unlikely to return.

Mr. Sohn thinks some workers have opted to stay home and raise their children while their spouses work. “Their attitudes are totally different about employment,” Mr. Sohn said. “They are really not in a hurry to come back to work.”

If he is right, then labor supply would remain tight, the unemployment rate would continue to fall, and rising wages would pressure inflation as companies compete for workers by boosting pay.

At his Senate hearing for confirmation to a second term Tuesday, Mr. Powell said the labor market was rapidly approaching or at maximum employment. Nonetheless, Fed officials have said a rebound in the labor force might come after the jobless rate drops, so it might take several more years to achieve the sorts of gains in employment that such a low unemployment rate would normally entail. Mr. Powell said high inflation could threaten such a rebound.

High inflation this time isn’t a symptom of a hot labor market but rather a threat to it, Mr. Powell said. It is tied to the pandemic—such as product shortages caused by supply-chain disruptions and stronger demand that resulted from aggressive stimulus—rather than rising wages, he argued.

The Fed’s plans to slowly raise interest rates this year aren’t in response to a labor market that has achieved full employment but rather an attempt to help it get there, he said. “Achievement of maximum employment, by which we really mean continued progress in hiring and in participation, is going to require price stability,” Mr. Powell said.

Some private-sector economists who agree with Mr. Powell point out that the U.S. still has roughly 3.6 million fewer jobs than just before the pandemic. They say the unemployment rate is artificially low because of the depleted pool of job hunters which they attribute to Covid-19, a shortage of child care, and virus-related school closures that are keeping many workers on the sidelines. In coming months, as vaccination or immunity reduces illness or fear of it and household savings are depleted, workers will return to the labor force, these economists say.

Still, there are big questions about the long-term supply of labor. Immigration has fallen sharply and it is unclear whether it will recover while some workers might be unable to return to the job because of long-term Covid-19 complications, said Diane Swonk, chief economist at the advisory firm Grant Thornton LLP.

Whether the U.S. is at full employment is “not an easy question to answer because the virus has distorted so much of the supply of employment that the economy,” she said.

Nick Bunker, head of research at the job site Indeed.com, points to another metric suggesting the labor market recovery still has room on the runway. The prime age employment-to-population ratio, the percentage of Americans aged 25 to 54 who are employed, was just 79% in December, 1.5 percentage points below where it was in February 2020. Since anyone in this group that left employment is probably too young to retire, they are more likely to return.

If the Fed prematurely determines that the economy is at full employment and moves too quickly to raise interest rates, “The big risk is there potentially could be millions of people who want a job and won’t be able to get it,” because higher interest rates will choke off the recovery, Mr. Bunker said.

—Nick Timiraos contributed to this article.

Write to Josh Mitchell at [email protected]