Most of the recent decline in US labor force participation may reverse, with the unemployment rate expected to rise modestly to 4.3% by year-end

Overview

This US economics weekly focuses on the decline in labor force participation and updates its assessments of oil, financial conditions, tariffs, GDP, and near-term data forecasts. The report's baseline view is that labor supply has not suffered a lasting disruption and that the unemployment rate will rise modestly to 4.3% by year-end. At the same time, weak consumption has reduced the third-quarter growth tracker, while oil prices and tariffs continue to generate inflation uncertainty.

Core views

On the labor market, the report argues that the recent decline in labor force participation may overstate the degree of tightening in labor supply. After correcting for the effects of the US Bureau of Labor Statistics' annual population adjustments, the labor force participation rate was broadly flat from June 2025 through May 2026, but then fell by a cumulative 0.4 percentage point over the next two months. Meanwhile, nonfarm payroll growth is slowing. Morgan Stanley still expects labor supply to be sufficient for the unemployment rate to rise modestly from 4.1% in July 2026 to 4.3% in December. This forecast depends on most of the recent participation decline reversing, particularly through a rebound in prime-age participation. Overall labor force participation fell by 0.3 percentage point in June, with the entire decline attributable to prime-age workers. The decline among women aged 25 to 34 was approximately half as large as at the start of the pandemic, but other data and market observations provided no corroborating evidence; only about half of the decline was recovered in July. The decline among prime-age men was spread across several age groups and weighed on overall participation by roughly as much as the decline among women, but did not reverse at all in July. The report acknowledges that it cannot currently explain these two changes clearly, but believes they interrupted a previously emerging upward trend rather than confirming a new trend. If prime-age participation remains at its July level, it will be approximately 0.5 percentage point below the previous December's level at year-end, leaving labor supply tighter than in the baseline forecast and lowering the unemployment rate. The report uses breakeven employment growth to illustrate the importance of participation: a 1 percentage point decline in prime-age participation would lower overall participation by approximately 0.5 percentage point; the current increase in nonfarm payrolls needed to keep the unemployment rate unchanged is approximately 50,000 per month. If prime-age participation were to decline at a pace of 1 percentage point per year, breakeven employment growth would fall to slightly below zero. Combined with the current employment forecast, the unemployment rate could be slightly below 4.0% by year-end instead of rising to 4.3%. Whether prime-age participation rebounds is therefore the most important uncertainty in the labor market forecast. Changes among young and older cohorts are considered easier to explain. The decline in youth labor force participation in July likely reflects distortions in summer employment seasonal factors. In recent years, participation among high school- and college-age people has fallen sharply during the summer and rebounded in the fall, and the report expects a similarly rapid reversal this fall, as occurred last year. Declines in youth participation typically coincide with declines in overall and prime-age participation rather than serving as a leading signal of a broader downturn. The decline in participation among those aged 55 and older primarily reflects the population gradually entering retirement-age groups with lower participation rates. Participation among those aged 55 to 64 and in older groups has changed little since the beginning of the year, and there is no evidence that rising wealth is accelerating retirement. The report's existing employment forecast already incorporates an assumption that population aging lowers overall participation by 0.2 percentage point annually, and it continues to maintain that estimate. The direct impact of Temporary Protected Status policy on labor supply is expected to be small and gradual. Approximately 350,000 Haitians and 6,000 Syrians have Temporary Protected Status. The report does not expect deportations to accelerate significantly. The US Department of Homeland Security indicates approximately 1,000 deportations to Haiti per month, about twice the recent pace of deportations to Haiti but only 7% of total monthly deportations. Morgan Stanley's labor market forecast already incorporates approximately 30,000 total deportations per month. The primary risk is that the July 27 revocation of status also cancels work authorization, meaning the impact could emerge before actual deportations occur. Approximately half of the affected Haitians live in Florida, where roughly 93,000 represent 0.8% of the state's labor force. August employment data and the state employment report released on September 18 will provide more meaningful tests. On oil, as of August 14, total US crude oil and petroleum product inventories were broadly unchanged from the previous week, but the Strategic Petroleum Reserve continued to decline to approximately 293 million barrels, its lowest level since April 1984. The Department of Energy estimates that operational constraints associated with storage cavern mechanisms imply a conservative lower operating limit of approximately 70 million barrels for the overall system. If the Strategic Petroleum Reserve continues to decline at its recent pace of approximately 30 million barrels every four weeks, it will approach that lower limit by the end of February 2027. The latest US domestic crude oil production was broadly stable but has generally trended higher since early May. Crude oil exports have gradually declined since April, driving a rebound in net imports of crude oil and petroleum products. After tensions between the United States and Iran escalated again, spot and futures oil prices rose anew, reversing the decline that had briefly followed the signing of a memorandum of understanding between the two sides and rekindling inflation concerns. As of August 18, the WTI spot price in Cushing, Oklahoma, was $86.48 per barrel, while the European Brent spot price was $95.29 per barrel. The report's scenario framework also treats the energy shock as the main point of divergence for growth and inflation trajectories. The five scenario weights are 20% for stronger demand and “animal spirits,” 10% for AI-driven productivity gains accompanied by labor displacement, 45% for de-escalation with energy creating a modest drag, 15% for a permanent oil price premium, and 10% for a global oil-price-driven recession. In the upside scenario, GDP grows by 2.9% in 2026 and 3.1% in 2027. The weakest scenario assumes consecutive contractions in the third and fourth quarters of 2026, full-year growth of only 0.1% in 2026 followed by a rebound to 2.5% in 2027, and unemployment rates rising to 5.5% and 5.3%, respectively. Financial conditions show a combination of recent easing and cumulative tightening since the conflict began. As of the August 20 close, financial conditions remained tighter than before the escalation in the Middle East but were materially easier than before the July FOMC meeting. They have eased by a cumulative 25 basis points since that meeting, primarily driven by positive equity returns and US dollar depreciation. The temporary easing caused by the US Treasury's August 19 buyback announcement had largely reversed by August 20. Since the Middle East conflict began on February 28, the cumulative economic impact of tighter financial conditions has been equivalent to an approximately 29 basis point increase in the federal funds rate, mainly because the previous weakness in the US dollar reversed and the 10-year US Treasury yield rose. Oil prices have recently begun contributing again, while stronger equities and US dollar depreciation have offset part of the tightening. On tariffs, the Office of the United States Trade Representative's final Section 301 action related to forced labor was broadly consistent with the report's expectations. Beginning July 24, tariffs were imposed on imports from 60 economies: economies that have adopted, partially adopted, or committed to adopting forced-labor import bans are subject to a 10% rate, while most other economies are subject to a 12.5% rate. Goods covered by Section 232, USMCA-compliant imports, and several general and country-specific products remain exempt. The effective tariff rate in May 2026 is estimated at approximately 6.9%, averaging 6.8% from March through May. The report continues to expect the statutory effective tariff rate to approach 10% by year-end. It also uses withdrawals associated with US Customs and Border Protection in the US Treasury's daily cash flows as a high-frequency proxy for tariff refunds, tracking cash returned to importers as a result of exemptions, court rulings, or refund applications. On growth, weak retail sales a week earlier led Morgan Stanley to lower its third-quarter real GDP growth tracker from 2.7% to 2.2%. A decline in goods consumption in July and downward revisions to prior months reduced the third-quarter consumption growth tracker from 2.4% to 1.8%. Subsequently weaker July housing starts also lowered the estimate for residential investment, though the effect on overall GDP was small. This forecast is materially weaker than the Atlanta Fed's, with the key difference being inventory investment. The Atlanta Fed expects an inventory rebound to contribute 1.7 percentage points, while Morgan Stanley currently assumes no boost from inventories. Because the real inventory-to-sales ratio is low, businesses may indeed accelerate restocking, but the timing of the restocking and whether it is achieved through imports or domestic production will determine its specific contribution to GDP. Near-term data forecasts further illustrate the combination of slowing growth and still-sticky inflation. The report expects core PCE to rise 0.23% month over month in July and headline PCE to rise 0.14%. The three- and six-month annualized growth rates of core PCE are expected to slow from 2.89% and 3.76% in June to 2.79% and 3.30%, respectively, while the year-over-year rate edges down from 3.29% to 3.27%. Alternative measures are more moderate: market-based core PCE is expected to rise 0.13% month over month, while trimmed-mean PCE is expected to rise 0.18%. Real consumption is expected to be unchanged month over month in July, with goods down 0.5% and services up 0.2%. Nominal personal income is expected to rise 0.2%, real disposable income to remain unchanged, and the saving rate to stay at 2.7%. Housing and other recent indicators are similarly moderate. Year-over-year growth in the Case-Shiller National Home Price Index recovered from a March low of 0.8% to 1.1% in May, and the housing strategy team expects 2% year-over-year growth by year-end. July new home sales are expected at 625,000 units, down 0.5% from 628,000 in June. Consumer confidence remains low, with the net share of respondents in July saying jobs are plentiful rather than hard to get falling to 3.1%, compared with 11.0% a year earlier. The revision tracker for second-quarter real GDP stands at an annualized quarter-over-quarter rate of 1.4%, slightly below the initial estimate of 1.5%, while consumption growth may be 3.1% to 3.2%. The nominal goods trade deficit is expected to widen from $101.4 billion to $103.0 billion in July, while initial unemployment claims are expected to remain at 206,000. Finally, the report expects the preliminary estimate of the annual nonfarm payroll benchmark revision to be modest because, through December 2025, the 12-month change in private employment and the preceding slowdown shown by the Quarterly Census of Employment and Wages and the nonfarm payroll survey were very similar, while the US Bureau of Labor Statistics' new methodology for estimating business births and deaths may have improved the accuracy of initial estimates. However, the preliminary revision will incorporate not-yet-released first-quarter 2026 Quarterly Census of Employment and Wages data, while current nonfarm payroll data show marked acceleration, so the quarterly data could still change the outcome. The report also expects Fed Chair Warsh not to provide forward guidance at the Jackson Hole meeting, although other officials may use impromptu media appearances to comment on recent data and the economic outlook.

Analysis framework

The report first adjusts labor force participation for population controls and decomposes it into prime-age, youth, and age-55-and-older cohorts to determine whether the recent decline reflects structural change, seasonal error, or population aging. It then uses breakeven employment growth to estimate how changes in participation affect the unemployment rate. Other sections track the oil market using inventory, production, trade, and price data; construct a financial conditions index using the FRB/US model; monitor tariff revenue and refunds through Treasury cash flows; and update GDP tracking forecasts on a rolling basis using newly released consumption, housing, and inventory data. Finally, the report uses probability-weighted energy and demand scenarios to illustrate different paths for growth, employment, and inflation.

Methodology notes

• (Out-of-vocabulary method)

  Population-control adjustment and age-group decomposition of labor force participation

  The report first removes distortions caused by the US Bureau of Labor Statistics' annual population-control adjustments, then separately examines prime-age, young, and older workers to distinguish genuine changes in labor supply from seasonal distortions and population-aging effects.

• Macroeconomic framework

  Breakeven employment growth analysis

  This method estimates the monthly employment growth required to keep the unemployment rate unchanged under given labor force participation and population changes. The report uses it to show that a sustained decline in prime-age participation would significantly lower breakeven employment growth and could, counterintuitively, reduce the unemployment rate.

• Macroeconomic framework

  FRB/US Financial Conditions Index

  The report aggregates the 10-year US Treasury yield, S&P 500 returns, BBB credit spreads, US dollar valuation, and oil prices according to their growth elasticities, then converts the result into a change in federal funds rate basis points with a similar effect on economic activity.

• Macroeconomic framework

  Real-time GDP tracking and component contribution comparison

  Morgan Stanley updates its quarterly GDP estimate on a rolling basis using the latest consumption, housing, and inventory data, and compares it with the Atlanta Fed forecast to identify the main divergence arising from inventory investment assumptions.

• Event Games and Behavioral FinanceEvent-driven analysis

  Probability scenario analysis of energy shocks

  The report assigns probabilities to five scenarios—stronger demand, AI productivity, de-escalation, a permanent oil price premium, and an oil-price-driven recession—and compares the growth, employment, and inflation trajectories under each.

• Macroeconomic framework

  Fiscal cash-flow proxy for tariff refunds

  The report treats withdrawals associated with US Customs and Border Protection in daily US Treasury data as a high-frequency proxy for tariff refunds, supplementing its monitoring of cash refunds actually received by importers.

Key data

• Recent cumulative change in labor force participation-0.4 percentage pointCumulative decline from June to July 2026
• Change in labor force participation in June-0.3 percentage pointThe entire decline came from prime-age workers
• Unemployment rate forecast4.3% in December 2026Higher than 4.1% in July 2026
• Breakeven employment growthApproximately 50,000 per monthCurrent estimate of the employment increase required to keep the unemployment rate stable
• Assumed impact of aging on participation-0.2 percentage point per yearAlready incorporated into the labor market forecast
• Population covered by Temporary Protected StatusApproximately 350,000 Haitians; approximately 6,000 SyriansThe report expects the revocation of status to have a small and gradual impact on national labor supply
• Affected labor force in FloridaApproximately 93,000 people, accounting for 0.8% of the state's labor forceHaitians holding Temporary Protected Status
• Strategic Petroleum ReserveApproximately 293 million barrelsAs of August 14, 2026, the lowest level since April 1984
• Lower operating limit of the Strategic Petroleum ReserveApproximately 70 million barrelsConservative estimate from the Department of Energy based on storage cavern mechanisms
• WTI spot price$86.48 per barrelCushing delivery price as of August 18, 2026
• Brent spot price$95.29 per barrelAs of August 18, 2026
• Change in financial conditionsEased by 25 basis points since the July FOMC meetingPrimarily driven by positive equity returns and US dollar depreciation
• Change in financial conditions since the conflict beganTightened by approximately 29 basis pointsMeasured from February 28, 2026, as an equivalent change in the federal funds rate
• Effective tariff rateApproximately 6.9% in May 2026; 6.8% average from March through MayThe report expects it to approach 10% by year-end
• Third-quarter real GDP growth tracker2.2%Lowered from 2.7%
• Third-quarter consumption growth tracker1.8%Lowered from 2.4%
• Atlanta Fed inventory contribution assumption1.7 percentage pointsMorgan Stanley currently assumes no inventory boost to third-quarter GDP
• July core PCE forecast0.23% month over month, 3.27% year over yearThe year-over-year rate is slightly below June's 3.29%
• July real consumption forecastUnchanged month over monthGoods down 0.5%, services up 0.2%
• July goods trade deficit forecast$103.0 billionExpected to widen slightly from $101.4 billion

Impact & implications

The report argues that the primary change in the US labor market remains slowing labor demand rather than a permanent contraction in labor supply. If prime-age and youth participation rebound as expected, the unemployment rate will rise modestly to 4.3%. Growth is cooling because of weaker consumption, although low inventories could provide support from restocking in the future. At the same time, renewed increases in oil prices, the continued decline in the Strategic Petroleum Reserve, and the effective tariff rate's approach toward 10% mean that inflation and financial-condition trajectories remain highly dependent on geopolitical developments, energy prices, and policy implementation.

Risks

• If prime-age labor force participation fails to rebound as expected, labor supply will be tighter than in the baseline forecast and the unemployment rate could fall to slightly below 4.0% by year-end.
• The simultaneous cancellation of work authorization when Temporary Protected Status is revoked could cause the labor supply impact to emerge before actual deportations, with Florida the most likely place for it to appear first.
• Renewed escalation between the United States and Iran has pushed oil prices higher, and the report warns that this will increase inflationary pressure again.
• If the Strategic Petroleum Reserve continues to decline by approximately 30 million barrels every four weeks, it could approach the conservative lower operating limit of approximately 70 million barrels by the end of February 2027.
• The third-quarter GDP forecast depends on when businesses restock and whether restocking comes from imports or domestic production; Morgan Stanley and the Atlanta Fed differ significantly on this component.
• The not-yet-released first-quarter 2026 Quarterly Census of Employment and Wages data could change the result of the nonfarm payroll benchmark revision.

What to watch

• Watch whether the August nonfarm payroll report confirms that prime-age labor force participation has begun to rebound.
• Watch the August state employment data released on September 18, 2026, particularly changes in Florida following the cancellation of work authorization for Temporary Protected Status holders.
• Continue monitoring the Strategic Petroleum Reserve, total US crude oil and petroleum product inventories, domestic production, net imports, and oil prices.
• Watch whether the contributions of the 10-year US Treasury yield, the US dollar, equities, and oil prices to financial conditions continue to offset one another.
• Watch whether the statutory effective tariff rate approaches 10% by year-end as the report expects, as well as tariff revenue and refunds reflected in Treasury data.
• Watch the timing and scale of business restocking and the share achieved through imports versus domestic production.
• Watch whether July core PCE, personal consumption, personal income, and saving-rate data match the report's forecasts.
• Watch the preliminary estimate of the annual nonfarm payroll benchmark revision and the not-yet-released first-quarter 2026 Quarterly Census of Employment and Wages data.
• Watch Federal Reserve officials' comments on recent data and the economic outlook during the Jackson Hole meeting.