The U.S. labor-force participation rate has defied predictions of demographic-driven declines thanks to a strong economy that is pulling in and retaining more workers.

The rate’s trajectory from here will have big implications for a range of issues, including how fast the economy can grow, how much inflation it generates in the process and whether the Federal Reserve will continue to feel comfortable keeping interest rates so low.

Since bottoming out in September 2015, the share of the population aged 16 and over working or looking for work has stabilized around 63%, cutting against an extended decline tracing back to 2001. Many economists had been predicting continued declines in the rate.

In just the past six months, the number of people outside the labor force has fallen by 1 million, the largest such decline on record.

“The performance of labor-force participation over the last three or four years has been an upside surprise that most people didn’t see coming,” said Fed Chairman Jerome Powell at a news conference this week.

A multitude of job openings and steadily rising wages are drawing more workers in their prime working years, 25 to 54 years old, off the sidelines. Meanwhile, effects from an aging population, which economists had expected would tug down the participation rate, have been partially offset by rising participation among older workers, even those of retirement age.

With more people in the workforce than expected, the economy might be able to grow faster without pushing up inflation in a way that would warrant interest rate increases by the Fed.

“It would suggest there’s less inflationary pressure associated with the unemployment rate being as low as it is,” said former Fed Chairwoman Janet Yellen in an interview.

The prospect for this supply-side boost was always at the back of her mind when she ran the Fed from 2014 to 2018 and moved interest rates up only gradually even as unemployment fell. The shift in participation has been even more dramatic than she had anticipated, she said.

Most of the improvement comes from 25 to 54-year-olds. Among prime-age workers, participation has risen by around 0.6 percentage point for men and 1.5 points for women since 2014. Most of the increases have stemmed from higher participation rates by workers who reported that they had a disability or were discouraged, meaning they wanted to work but stopped actively seeking employment, according to an analysis by Ernie Tedeschi, an economist at Evercore ISI.

How much scope remains for these gains to continue? The prime-age participation rate in February stood nearly 1 percentage point below the high level reached during the 2001-07 expansion and two points below the all-time peak in 1999. That suggests there is room for it to run higher.

Still, many labor-market specialists say that even if the economy continues to run at a solid pace, the strength of the labor market likely won’t prove enough to offset the powerful downward drag from the aging population in the coming years.

Americans over the age of 65 work at much lower rates than their younger counterparts, meaning that as they increase as a share of the population, the labor-force participation rate will likely decline. Just about 20% of Americans over 65 work or look for work. Even if that share rises, it is still a long way from participation rates for younger people.

“Eventually the boomers are really going to start retiring, and there are a lot of them,” said Stephanie Aaronson, a former Fed economist who is now at the Brookings Institution in Washington, D.C.

Demographic trends should shave another 2.5 percentage points off participation rates over the next decade, according to researchers at the San Francisco Fed. Fewer workers could weigh on growth and make it harder to expand the economy without causing pressure on wages and inflation.

Mr. Powell spent two days of congressional testimony last month gently urging lawmakers that despite recent improvements, broader policy changes outside of the central bank’s remit–to education, training and the social-safety net–are needed to sustain recent improvements through good times and bad.

The White House Council of Economic Advisers also focused on the need to expand participation in its annual Economic Report of the President released this week. It mentioned the potential benefits of deregulation.

While recent increases in workforce participation are gratifying, Mr. Powell said they still leave the U.S. lagging far behind other well-off countries. Improving this is “going to need more than a good labor market,” he said.

The U.S. has one of the lowest rates of growth in female labor-force participation since 2000, among the 36 countries in the Organization for Economic Cooperation and Development.

For women 21 to 40 years old, participation stopped rising over the last two decades after climbing for the previous half-century. Economists have said this could highlight the need for more flexible workplace policies around child care.

Even if officials conclude the labor market has further room for recovery, they don’t know how long it will be before the next recession hits.

“And when–not if–it hits, the same labor-market weakness around disability, child care, part-time work, etc., could all arise again without policy changes to address them,” said Mr. Tedeschi.

Write to Nick Timiraos at [email protected] (mailto:[email protected]) and Sarah Chaney at [email protected] wsj.com (mailto:[email protected])

-Nick Timiraos ; 415-439-6400; [email protected]

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  03-24-19 0736ET
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