Research indicates that inflation was the cause, rather than the result, of the ‘hot’ labor market.

In 2022, during the period when the labor market seemed particularly “hot,” Americans were frequently switching jobs, boosting their salaries in the process. This was seen as part of the Great Resignation. Concerns arose about a potential “wage-price spiral,” where wages and prices would continuously rise in a self-reinforcing cycle. However, new research suggests that the hot job market was actually a result of inflation, not its cause.

The study, titled “A Theory of How Workers Keep Up With Inflation,” argues that rising prices were eroding people’s paychecks, prompting workers to make costly decisions, such as changing jobs, to maintain their standard of living. This, in turn, increased job vacancies, while layoffs and the overall unemployment rate remained historically low, creating the illusion of a tight labor market.

Co-author Erik Hurst, an economist at the University of Chicago Booth School of Business, explains that in times when labor demand increases, real wages rise, employment grows, and job-finding rates improve. However, none of these indicators were present during this period. In fact, real wages (adjusted for inflation) were about 4.4% lower than expected based on pre-pandemic trends.

Additionally, data from the Bureau of Labor Statistics showed that real average hourly earnings had declined for 25 consecutive months. While average hourly pay has recently outpaced inflation since May 2023, it still hasn’t returned to pre-inflation levels.

Inflation is driving the need for expensive decisions.

In early 2021, as workers were rapidly losing income, they probably took measures to prevent further losses, based on a paper co-authored by Hurst alongside economists from Columbia University, the Federal Reserve Bank of Atlanta, and the University of Texas at Austin.

On September 9, 2021, in Inglewood, California, people stood in line at SoFi Stadium to attend a job fair offering employment opportunities with SoFi Stadium and Los Angeles International Airport employers.

The economists stated that potential responses to wage erosion included renegotiating wages within their current company, exploring opportunities at other firms, or simply quitting and relying on unemployment if wages were deemed too low.

They pointed out that each option involves additional costs. Renegotiating wages may result in less frequent future pay increases and could be seen as a sign of disloyalty. Job searching involves both direct financial costs and indirect ones, such as stress, health issues, and reduced productivity. Unemployment carries significant risks, such as lost income, skill deterioration, and broader economic impacts.

Hurst suggested that inflation may have been a contributing factor to the “Great Reshuffling.”

How the hot labor market played into an extended pause

At the time of this activity, when the vacancy-to-unemployment rate reached historically high levels, it created uncertainty among academics, economists, and key policymakers, according to the paper.

In November 2022, six months after the Federal Reserve began raising interest rates, Fed Chair Jerome Powell stated that “the broader picture is of an overheated labor market where demand exceeds supply.” It wasn’t until two years later, when the labor market showed signs of rapidly weakening, that the Fed started to reduce interest rates with a large, half-point cut.

Hurst noted that policymakers were hesitant to act too quickly due to concerns about the inflationary risks of a “hot” labor market. He added that gaining a clearer understanding of labor market dynamics would provide valuable insights for future policy decisions.

This could involve examining changes in wages, reasons for quitting, hiring trends, and shifts in how job seekers find employment. Such data could be crucial in determining whether the labor market is driving inflation or if inflation is influencing the labor market.