The U.S. unemployment rate declined to 3.7%, a rate unseen in almost half a century, the Bureau of Labor Statistics reported Friday. Given the booming labor market, the Federal Reserve has reason to worry that the economy may be overheating. Although we are getting close to the peak of the business cycle, three labor-market indicators suggest we’re not there yet: Job growth is too high, wage growth is too low, and the employment rate is still slightly below the level consistent with full employment.
First, consider the rate of job creation. Jobs must be created every month to keep up with population growth. Throughout a business cycle, labor economists can determine whether the number of new jobs is sufficient to keep pace with the added population using the employment-to-population ratio. The U.S. EPOP currently stands at 60.4%. It’s always well below 100% because some people are retired, at home or in school. Population growth over the past year has averaged 227,000 a month, so the U.S. economy must create 137,000 jobs monthly—60.4% of the population change—to keep up.
September saw 134,000 new jobs created—almost exactly the full-employment number. But the three-month average is 190,000 jobs created a month. (The three-month average is more accurate because of month-to-month volatility; monthly numbers have an average error of about 75,000.) Because 190,000 significantly exceeds the 137,000 threshold, the U.S. labor market is creating jobs at a rate faster than required to absorb the added population.
This suggests the U.S. isn’t yet at full employment. When the economy is at full employment, job creation is just large enough to keep up with population growth, neither increasing nor decreasing unemployment rates or EPOP. When the economy is recovering, job growth exceeds population growth, which makes up for jobs lost during a recession. The current rate of job creation points to a labor market still in the recovery phase.
Another clue that full-employment hasn’t been achieved is that the EPOP remains below its full-employment level. The prerecession EPOP peak of 63.4% will not likely be reached because the population is aging and retirees depress the EPOP’s natural level. But a peak rate that accounts for demographic changes is closer to 61%, according to the Council of Economic Advisers and a National Bureau of Economic Research report. That’s still half a percentage point above where the U.S. is now. More evidence that the economy isn’t at peak employment is that the employment rate of 25- to 34-year-olds, depressed throughout the economic recovery, is now growing. It has risen by a full percentage point since January, suggesting there are still people to pull back into the workforce.
Finally, the rate of wage growth indicates that the labor market isn’t overheated. When the economy runs out of workers, labor demand drives increased wages rather than employment as employers compete with each other for the scarce labor. Absent labor-market slack, wages tend to grow at rates above those consistent with target inflation and productivity increases. Wage growth at rates consistent with productivity growth isn’t inflationary, since additional output from increased productivity reduces upward pressure on prices. U.S. productivity growth has averaged 1.3% over the past four quarters. Add the Fed’s 2% target inflation figure to get 3.3%. This exceeds the 2.8% actual rate of wage growth over the past 12 months. If the economy were overheating, wages would be growing at a faster rate.
Despite the low unemployment rate of 3.7%, the U.S. labor market has some room to expand before it hits full employment. That’s good news: The Fed need not worry that the tight labor market is indicative of an overheated economy—yet.
Mr. Lazear, who was chairman of the President’s Council of Economic Advisers from 2006-09, is a professor at Stanford University’s Graduate School of Business and a Hoover Institution fellow.