Boomers lowering unemployment the wrong way

The flip side of the problem, of course, is that we need younger workers to pick up the slack from retiring baby boomers. We need them to take over jobs, produce stuff and pay taxes.

Instead, the young are having trouble getting started even as boomers are leaving at an increasing pace.

You see, in addition to the workforce churn caused by the recession, we have an underlying demographic changing of the guard. Older, highly skilled and motivated workers are leaving -- choosing retirement, having it forced on them or becoming "self-employed" or "consultants" -- often euphemisms for "laid off and can't find a job worth taking."

Companies are left with the prospect of replacing theses workers from a narrower field of less-efficient replacements. That translates to lower productivity, higher labor costs, rising prices to make up the difference and slower economic growth.

It's one reason that, even though the economy is running 5% below its potential output (a loss of nearly $1 trillion in economic activity), inflation has returned to pre-recession levels and is above the Federal Reserve's 2% target. Simply put, the economy has slipped a gear when it should be upshifting instead.

It's these retiring boomers who have been pulling down the unemployment rate so dramatically of late. If the drop were driven by new high-paying, high-quality jobs, the improvement would be showing up in growth in the gross domestic product, wages and spending, says Société Générale economist Aneta Markowska. That's not the case.

And that calls into question the validity of interpreting the recent drop in the unemployment rate as an unabashedly positive sign. In addition to some seasonal factors that may be distorting the numbers, it's masking ongoing problems.

Yes, job creation has improved. But, as Fed Chairman Ben Bernanke recently warned, the drop in the unemployment rate from 9.1% in August to 8.3% now overstates labor market strength because of people leaving the workforce. The chart below illustrates the precipitous fall in this measure -- a fall that, according to UBS economists, is well outside the realm of historical post-recession experiences.

Civilian participation rate

In a traditional recovery, the participation rate increases as new jobs bring people back into the workforce. This time, the opposite is happening. That's because as older workers (with high participation rates) retire or die, the overall participation rate is pulled down as younger workers (with lower participation rates) increase as a share of the population.

UBS economist Maury Harris crunched the numbers and found that of the 5.5 million workers who left the workforce after 2006, only 20% left because they were discouraged by being unable to find a job. The rest were a result of demographics.

What's more, the trend is set to continue, adding more downward pressure to unemployment and productivity while pushing up labor costs and inflation for years to come. Harris believes the aging of baby boomers will drive the labor participation rate down to 62.7% by 2020 -- a level not seen since the 1970s.

Hitting the limit

The consequence of this, all other things being equal, will be a drop in labor-market efficiency. In layman's terms, that means pressure to raise wages to get the right workers in select, high-skill industries. It also means fewer overall jobs created, rising prices and lower profitability as companies try to pass on higher labor costs to consumers.

This can be seen in the Beveridge Curve, a wonky tool economists use to measure the relationship between the supply (unemployment) and demand (job vacancies) of labor. The curve has recently shifted and flattened. Translation: It's harder to find the right worker for the right job.

As a result, there are now 3.7 workers for every job vacancy versus a historical average of 2.6. This is why we see both large numbers of unfilled jobs and millions of unemployed workers. They don't match up. It's like trying to fit a square peg into a round hole.

According to Harris, this shift has increased the economy's natural unemployment rate by 1.6% to something around 7.2% by his estimates. That means unemployment will be as low as we can get it without creating big-time inflation.

And it means that in the best-case scenario, seven of every 100 Americans who want to work won't be able to find jobs. That won't feel like a recovery.

That scenario points to a dire need to invest in the economy. We need corporations to tap their massive cash reserves for new machinery and worker training. We need state-of-the-art infrastructure systems and education to support those efforts. We need a more-efficient health care system. We need convince Americans young and old that work pays.

What it all means

The key and most immediate takeaway from this jobs picture involves the Fed: Despite an unhealed labor market, the Fed's stimulus efforts -- one of the few things bolstering the economy right now -- can't continue. Fed officials will have to break their pledge to hold interest rates near 0% through at least 2014 or else risk fueling growth-killing inflation.

I'm not the only one worried about all this. Federal Reserve Bank of St. Louis President James Bullard recently warned of the dangers of his colleagues' obsession with juicing an economy with an increasingly dysfunctional labor market.

For investors, it's critical to consider how these labor-market dynamics will limit the Fed at a critical time. Markowska believes Fed policymakers are worried that if growth slows again, it could exacerbate the job-market issues by increasing long-term unemployment, pushing more people out of the job market and increasing the natural unemployment rate.

Yet the window to act is closing. Move too soon, and the Fed risks losing inflation-fighting credibility. Wait too long, and it risks being seen as overtly political as Election Day approaches. Markowska believes action on additional stimulus, if it happens, will come in April or June as fresh data point to an emerging slowdown. Otherwise, Fed policymakers may have to wait until after November.

Plus, the upcoming Q1 earnings season could very well be the first featuring an outright contraction in year-over-year corporate earnings since the recession ended. Overall GDP growth has been disappointing as well.

None of this is good for people looking for jobs. And as investors, it means we need to stay nimble because the risks are high.

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More broadly, this is a reminder that there are deep structural problems at play not easily solved with cheap credit from central banks. We face a situation of rising interest rates, higher inflation and lower employment -- even as the unemployment rate falls because fewer people are looking for work. And don't forget, unless we get the young adults revved up, America will face a gray tsunami as more seniors, collecting government benefits, rely on fewer and fewer taxpaying youngsters.

Flat wages, a rising cost of living, unattractive jobs and the specter of more taxes. I guess that's why many in my generation just don't see the point of getting up and going to work in the morning.

Be sure to check out Anthony's new money management service, Mirhaydari Capital Management, and his investment newsletter, the Edge. A free, two-week trial subscription to the newsletter has been extended to MSN Money readers. Click here to sign up. Mirhaydari can be contacted at anthony@edgeletter.com and followed on Twitter at @EdgeLetter. You can view his current stock picks here. Feel free to comment below.