Wage Growth and Labor Market Tightness

Abstract

Good measures of labor market tightness are essential to predict wage inflation and to calibrate monetary policy. This paper highlights the importance of two measures of labor market tightness in determining wage growth: the quits rate and vacancies per effective searcher (V/ES)—where searchers include both employed and non-employed job seekers. Amongst a broad set of indicators of labor market tightness, we find that these two measures are independently the most strongly correlated with wage inflation both in aggregate time series data and in industry-level panel data, and also predict wage growth best out of sample. Transitory shocks to productivity have little impact on wage growth. These results are consistent with the predictions of a New Keynesian DSGE model where firms have the power to set wages and workers search on the job. Based on our findings, we develop a new composite indicator of labor market tightness that can be used by policymakers to predict wage pressures in real time.

Keywords: wage Phillips curve, labor market slack, labor market tightness, on-the-job search, monopsony

JEL Classification: E3, J6