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By Matt McDonald and Russ Grote, (202)-822-1205, mmcdonald@hamiltonps.com.

With 162,000 jobs added in July, the economy seems to have (once again) settled on a path of modest job growth. The HPS Jobs Day Model still forecasts that the Fed will hit 6.5 percent by mid-2015, as it only needs 169,000 jobs per month to reach the mark. By comparison, we have created on average 170,000 jobs per month over the past year. However, Fed action is not solely determined by the unemployment rate. Other factors will impact Fed decisions going forward, and the most impactful variable on the unemployment rate during the recovery has not been job creation, but drops in the participation rate.

In July, the unemployment rate fell to 7.4 percent not entirely due to job growth (227,000 in the household survey), but also due to the drop in the labor force participation rate. In fact, this dynamic mirrors a long-run trend. Since the recession ended in 2009, the employment rate has barely budged, while the unemployment rate has fallen over 2.5 percent.

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The question for Fed followers is, “At what point does the Federal Reserve move away from its 6.5 percent commitment?”

For example, if the labor force participation rate were to fall further, to say 62.8 percent over the next two years, hitting 6.5 percent might be seen as an artificially easy goal to reach. At the same time, one might view the Fed’s actions as relatively powerless at impacting this trend. Behind both of these conclusions are different beliefs about the driving force behind the fall in the labor force participation rate.

If the drop in labor force participation is mostly due to cyclical reasons, as articulated by a 2012 analysis by Ed Lazear and James Spletzer, then the Fed may consider more accommodative policies. With higher growth, labor force participation will rise back to the demographic trend. However, if the move in the labor force participation is structural, the Fed is powerless and it’s up to Congress to enact supply side reforms to improve labor market outcomes. For Fed watchers, the answer to this critical question will impact expectations in the years ahead.

Matt McDonald is a partner at Hamilton Place Strategies and a veteran of three Presidential campaigns and the White House. Prior to joining HPS, Matt worked for McKinsey and Company. He holds an MBA from MIT’s Sloan School of Management and a degree in economics from Dartmouth College.

Russ Grote is an analyst at Hamilton Place Strategies. Prior to joining HPS, Russ conducted field research on the economic development in the EU. He holds a BA from the University of North Carolina at Chapel Hill.