Unpacking Inflation: How Tight Labor Markets Drive Wage Growth and Services Inflation in the U.S – KE Andrews

A report issued by the International Monetary Fund, titled “Inflation and Labor Markets: A Bottom-Up View,“ examines the intricate relationship between inflation and labor market conditions, with a specific focus on the U.S. service sector. It highlights how inflation trends diverged post-pandemic, with goods inflation peaking and subsequently declining sharply, while services inflation remained elevated. The study investigates how local labor market tightness — measured by the ratio of job vacancies to unemployment — affects service sector wage growth and, in turn, services inflation.

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Using granular wage data from Homebase and inflation data from the Bureau of Labor Statistics, the researchers employed advanced statistical models to uncover a significant wage-price pass-through. They found that tighter labor markets led to higher wage growth, which then contributed to inflation in the service sector. Specifically, a one-percentage-point increase in wage growth resulted in a 0.32-percentage-point increase in year-over-year services inflation. This process often took several months to manifest fully, demonstrating the persistence of labor market-driven inflationary pressures.

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The findings underscore that labor markets play a key role in driving inflation, particularly in services, where costs are heavily influenced by wages. Between Q3 2022 and Q1 2023, local labor market tightness accounted for nearly 69% of the observed services inflation across U.S. metropolitan areas. This suggests that managing inflation will require addressing labor market imbalances, especially in a post-pandemic environment marked by persistent labor shortages and wage pressures.

The study provides valuable insights for policymakers, emphasizing that services inflation — which is more persistent than goods inflation — will likely remain a critical factor in overall inflation trends. The document concludes by stressing the importance of considering local labor market dynamics in shaping effective monetary and fiscal policies.