Full Employment Liquidity Trap” may sound like an oxymoron, but this phenomenon does exist in Japan, Europe and in many other places.

For example, both Japan and Germany have been stuck in a liquidity trap, where interest rates have fallen to below zero for a long time. However, unemployment rates in both economies have been falling sharply this decade. 

Japan’s unemployment rate stands at a 27-year low of 2.2% as of today, while it is 3.7% in Germany, the lowest since 1970, according to Bundesbank statistics.

Looking at the unemployment rate alone, one would conclude that both the German and Japanese economies have been in a prolonged economic boom.

In reality, however, both have suffered economic stagnation, low inflation or deflation for long, and are now teetering on the brink of “technical recession” – again.     

The perverse combination of a “liquidity trap” and a very low unemployment rate forms a stark contrast to what John Maynard Keynes originally envisioned in 1936.

At the time, Keynes thought that the liquidity trap would be a rare occurrence where interest rates would fall to too low a level that monetary authorities would lose control over the economy.

He believed that only a financial crisis could push an economy into such a trap where aggregate demand is destroyed and “liquidity preference” becomes “absolute.”

As such, soaring unemployment and price deflation are the inherent characteristics of a classic “Keynesian liquidity trap”. 

Japan was in a classic “Keynesian liquidity trap” for nearly 25 years, precisely, from 1995 to 2010. During this period, Japan suffered stagnating growth, price deflation, zero interest rates and a high and rising unemployment rate. Since the beginning of this decade, however, Japanese labor market conditions have begun to quickly change.

While interest rates have stayed at extraordinarily low levels and economic growth continues to stagnate, Japan’s job openings have been increasing, the number of  job applicants has fallen, and the unemployment rate has plummeted since 2010.  

A similar phenomenon has also become evident across Europe in general, and Germany in particular. Germany’s unemployment rate peaked out in 2005 and has fallen precipitously since, with the 2008 Global Financial Crisis only briefly interrupting the broad downtrend.

Such a large and uninterrupted fall in unemployment has occurred against the backdrop of Germany’s stagnating economic growth, zero to negative interest rates and very low inflation, especially since 2010.     

The primary suspect that has caused this “full employment liquidity trap” is an aging population. If an economy experiences a stagnating or even shrinking labor force, its natural unemployment rate must fall precipitously.

To think about this issue more clearly, assume an extreme hypothetical case where only 10% of the population is in the prime-age labor force, with the rest either too young or too old to work. In this case, the “natural unemployment” rate should be zero, but the size of the economy must also shrink. 

Although Japan’s unemployment rate is approaching all time lows , real wage growth has stayed depressed this decade, averaging about -0.2% a year. In the meantime, bond yields and short rates have been either at or below zero.

The interesting question is: do we really know Japan’s steady state unemployment rate? Even at 2%, Japan’s unemployment rate may still be above its nonaccelerating inflation rate (NAIRU). Otherwise, why has Japan’s real wage fallen? 

The key point here is that when the population becomes older and labor force growth weakens, “full employment” has less macro influence. In Japan and Germany, the wage-inflation link has been severed for long, and the tightness of the labor market only provides misleading signals of underlying demand conditions.

As a result, the central bank’s only job seems to be to ensure price levels stay more or less stable. 

The U.S. may be some distance away from becoming Japan or Germany, but weakening labor force growth, a falling labor participation rate and an aging population have been big trends in recent decades. Labor force growth used to contribute 2.5% of GDP growth in the 1970s. Its contribution has fallen to a mere 0.4% currently.

Last decade, the U.S. labor participation rate was more than 67%. It has averaged 63% this decade. These demographic factors may very well be the main reasons behind low and falling unemployment, but weak real wage gains. 

What is certain is that with an aging labor force, America’s NAIRU has already fallen sharply, probably to levels that are much lower than most, including policymakers, think.

Therefore, the Federal Reserve needs to heed the message and experiences from both Japan and Germany and re-calibrate policy to account for the possibility of a “full employment liquidity trap.” Put it practical terms, central banks of high-income, mature economies should stop worrying about low unemployment causing inflation. They should be paying more attention to weak economic growth and guarding against price deflation.