Tight labor markets amplify wage response to policy shocks

A Norges Bank working paper, using U.S. state-level data and high-frequency-identified monetary policy shocks, finds pronounced nonlinearities in wage adjustment.

Expansionary monetary policy strongly raises wages, with pass-through up to four times larger in tight labor markets than in slack ones.

In contrast, contractionary shocks generate little wage decline at any tightness level, consistent with downward nominal wage rigidity.

These results imply that nonlinear monetary transmission arises partly at the wage-setting stage, where tight labor markets amplify wage responses during expansions, while wage rigidity limits adjustment during contractions.

This provides a microeconomic foundation for state-dependent inflation dynamics and helps explain recent strong wage growth and persistent inflation during exceptional labor market tightness.

The study combines national policy impulses with cross-state variation in labor market tightness to identify these effects.

The paper shifts attention to the wage-setting stage of monetary transmission, combining high-frequency-identified monetary policy shocks with cross-state variation in labor market tightness.

This approach identifies how national policy impulses translate into wage adjustments across heterogeneous local labor markets.

While existing literature documents nonlinear inflation responses, this study shows the underlying nonlinearity arises at the wage-setting stage.

This provides causal evidence on the labor-cost channel that underlies nonlinear inflation dynamics and the state-dependent effectiveness of monetary policy.

The findings suggest that aggregate inflation responses to monetary policy depend critically on prevailing labor market tightness, even if firms' price-setting behavior is itself linear.