Labour market flows predict inflation through novel unemployment gap
A new BIS working paper by Enisse Kharroubi and Marius Koechlin presents empirical evidence that labour market flows provide valuable insights into subsequent wage and price inflation. They introduce a novel unemployment gap measure, defined as the difference between flow-based and stock-based unemployment.
Flows reveal inflation's future
The working paper introduces a novel measure: the unemployment gap, defined as the difference between the unemployment rate implied by current labour market transitions (flow-based unemployment) and the observed, or stock-based, unemployment rate.
Empirical evidence from the United States demonstrates this gap provides valuable insights into subsequent wage and price inflation.
Inflationary pressures tend to subside when the unemployment gap becomes positive, indicating flow-based unemployment exceeds stock-based unemployment.
This measure captures the directional momentum of labour market dynamics, distilling complex worker transitions into a single indicator of labour market tightening or loosening.
A strong negative correlation with 12-month-ahead core CPI inflation is observed, with the gap correctly predicting inflation declines after recessions and surges after COVID-19.
Search-and-matching explains the gap
To further investigate this relationship and account for empirical findings, the authors develop a search-and-matching model.
This framework incorporates nominal wage rigidities and persistent shocks to transition probabilities.
While pre-existing workers face sticky wages, new hires can freely bargain, making firms' bargaining power endogenous to both stock- and flow-based unemployment.
Consistent with the empirical results, the model demonstrates that a larger unemployment gap—whether driven by higher flow-based or lower stock-based unemployment—typically leads to lower wages, provided shocks to transition probabilities exhibit sufficient persistence.
The paper argues that traditional stock-based measures failed to anticipate the rapid post-COVID inflation surge, highlighting the value of flow-based measures for timely signals.
A crucial new inflation compass
This paper offers a crucial new tool for central banks to forecast inflation, especially after recent predictive failures.
The novel unemployment gap provides a forward-looking indicator that static measures of labor market slack often miss.
Integrating this flow-based perspective could significantly enhance monetary policy effectiveness.