Alice Mollon
How Inflation Makes the Labor Market Appear Hot
In recent years, wages stagnated while corporations reaped record profits.
- By
- July 08, 2025
- CBR - Economics
Job listings in the United States in 2021 grew plentiful while unemployment was low. To many policymakers and academics, the labor market looked hot.
But those observers had it wrong, according to research by Columbia’s Hassan Afrouzi, Andrés Blanco of the Federal Reserve Bank of Atlanta, Andrés Drenik of the University of Texas, and Chicago Booth’s Erik Hurst. They argue that accounting for inflation, which started to surge in 2021 amid COVID-19, wages were actually lower than would have been expected on the basis of pre-pandemic trends. The burst of inflation only made the market appear tight, as workers looked for new jobs to keep up with rising prices.
Recognizing the importance of inflation in such cases could have a big effect on policymaking. If the Fed sees that workers’ wages are losing value, it might view that as a reason to cut rates. But “if the Fed thinks a hot labor market might make inflation even worse, it might not cut interest rates as quickly,” Hurst says. Thus, workers can end up getting burned by a labor market that’s not actually hot.
The aggregate vacancy-to-unemployment rate—which compares the number of job openings to the volume of job seekers—hit a record high in March 2022. Wages seemed to be going up too, consistent with the conventional wisdom that workers had the upper hand. But prices rose more than 14 percent cumulatively between April 2021 and May 2023, a huge jump from annual inflation rates that have, since 2000, averaged closer to 2 percent. After accounting for this, the researchers find that wages were about 4 percent below what would have been expected by looking at pre-2020 trends.
They collected responses from surveys by the Bureau of Labor Statistics and the US Census Bureau, as well as wage data from payroll processing company ADP. They then developed an economic model of labor flows in the economy that built on existing versions by accounting for the “stickiness” of wages (i.e., they don’t immediately rise to keep up with inflation) and the fact that workers incur costs when they negotiate a raise or look for a new role. (For more on these costs, read “Inflation Feels Doubly Bad for Workers.”)
A booming job market?
Few modern models of labor flows have incorporated the assumption of sticky wages, which is less meaningful when inflation is low. But introducing an unexpected increase in inflation into the researchers’ model produced effects similar to those seen in the US economy after 2021.
The model predicts that higher prices reduce the value of workers’ wages. Some workers may respond by renegotiating their contracts, and others may find better-paying positions, leading to higher turnover.
At the same time, because wages don’t rise as fast as inflation, labor effectively becomes cheaper for companies. This leads them to post more job openings, and because most people filling those roles are switching from an existing job, the unemployment rate holds steady. What looks like a hot market is not actually drawing in new workers. Rather, “it’s like a game of musical chairs,” Hurst says.
To validate the model’s predictions, the researchers looked at historical data and observed that the vacancy-to-unemployment rate went up during inflationary periods between 1950 and 2019. The same was true during Argentina’s skyrocketing inflation of the early 2000s.
This was the main reason that workers across all income levels experienced a large decline in welfare over this COVID period, note Afrouzi, Blanco, Drenik, and Hurst. Specifically, when inflation is accounted for, welfare losses amounted to about 75 percent of monthly real income for the bottom 10 percent of workers and 110 percent for those in the top 10 percent. On average, the researchers calculate, the typical worker lost a month’s worth of wages. “Imagine you just take one-twelfth of your yearly salary and throw it away—you could see why workers were upset,” says Hurst.
On the bright side, because inflation made labor cheaper, companies were less likely to lay off workers. Cheaper labor also helped create record corporate profits.
During periods of inflation, policymakers and other experts should be cautious about assuming that a high number of vacancies relative to job seekers signals a hot market, says Hurst. Instead, he advises, treat that metric as one among many and remember that inflation could be causing the labor market to only appear tight.
Hassan Afrouzi, Andrés Blanco, Andrés Drenik, and Erik Hurst, “A Theory of How Workers Keep Up with Inflation,” Working paper, December 2024.
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