Why the labor market is stronger than the unemployment rate indicates

At least 19% of the rise in the unemployment rate since last year can be explained by the increase in the labor supply. Since 2021, the return of workers to the labor force, in addition to immigration and population growth, has been a key driver of overall unemployment in the United States.

Even though such an increase in the labor supply might drive up the unemployment rate, it is typically a positive sign, as it often indicates either an economic recovery or sustained expansion, as seen in previous business cycles.

In contrast, during a recession, the demand for labor usually falls sharply, leading to widespread layoffs, and the spike in the unemployment rate is mostly demand driven, not supply driven.

By that measure, we are clearly not in a recession, despite growing concerns about a deterioration in the labor market.

If we exclude the increase in the labor supply, the unemployment rate—which has risen from a multidecade low of 3.4% last year—would have been 4% in August instead of 4.2%. That would still represent a strong labor market by any standard.

The market clearly overreacted to the weak July jobs report when the Sahm rule—a recession metric based on the rise in the unemployment rate—was triggered. But as Claudia Sahm, the creator of the rule, has said, the increase in total unemployment has been overstated because of the influx of workers, according to our analysis.

In our estimate, the new threshold for sounding the alarm on the unemployment rate is between 4.5% and 5%, slightly higher than the Federal Reserve’s latest forecast for an unemployment rate of 4.4% this year.

The Fed believes it can achieve the soft landing and has shown that it is not afraid to act aggressively if necessary.

That said, recent developments in the monthly data point to a somewhat concerning short-term trend, with demand-driven unemployment exceeding supply-driven unemployment in both July and August. This was one of the reasons we called for the Fed to cut rates during the July meeting.

Now, with a sizable 50-basis-point cut in September, the Fed has made up some lost ground by moving more aggressively than many had predicted. With plenty of room left for rates to fall further, we believe the Fed will be able to safely guide the economy to a soft landing.

Our methodology

We approximate the supply factor by tracking the flow of labor from the “not in labor force” category to the “unemployed” category, and the demand factor by tracking the flow of workers from “employed” to “unemployed.”

The remaining category within unemployment consists of workers who remain unemployed. We do not assign this category as demand- or supply-driven because the impact of either on this group is ambiguous. But this category makes up the largest portion of overall unemployment.

All data comes from the monthly job reports of the Bureau of Labor Statistics.