Working Paper

(Re-)Connecting Inflation and the Labor Market: A Tale of Two Curves

Abstract: We propose an empirical framework in which shocks to worker reallocation, aggregate activity, and labor supply drive the joint dynamics of labor market outcomes and inflation, and where reallocation shocks take two forms depending on whether they result from quits or from job loss. In order to link our approach with previous theoretical and empirical work, we extend the procedure for estimating a Bayesian sign-restricted VAR so that priors can be directly imposed on the VAR's impact matrix. We find that structural shocks that shift the Beveridge curve have different effects on inflation. Our model allows us to fully decompose movements of or along the empirical Beveridge curve in terms of the contribution of each shock and also allows us to estimate the Phillips correlation associated with each shock; our results imply that observed Beveridge and Phillips correlations can change over time depending on what types of structural shocks predominate in a given period. Applying our model to the pandemic-related recession and recovery, we find that reallocation shocks were a key source of labor market dynamics during this period and explain how a post-pandemic ``soft landing,’’ in which inflation declined without a significant rise in unemployment, was possible.

Keywords: Sign-restricted VAR; Bayesian methods; Labor market dynamics; Reallocation; Inflation; Beveridge curve; Phillips curve; Covid-19;

JEL Classification: C11; C32; E24; E31; E32;

https://doi.org/10.17016/FEDS.2024.050

Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: Finance and Economics Discussion Series

Publication Date: 2024-07-11

Number: 2024-050