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 University’s Hassan Afrouzi, Andrés Blanco of the Federal Reserve Bank of Atlanta, Andrés Drenik of the University of Texas and Erik Hurst of the University of Chicago’s Booth School of Business.

In a working paper published with the National Bureau of Economic Research, 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 said. 

Workers could 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% cumulatively between April 2021 and May 2023, a huge jump from annual inflation rates that have, since 2000, averaged closer to 2%. After accounting for this, the researchers find that wages were about 4% 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 U.S. 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—meaning 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.

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 U.S. 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 said. 

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% of monthly real income for the bottom 10% of workers and 110% for those in the top 10%. 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,” said 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, they should treat that metric as one among many and remember that inflation could be causing the labor market to only appear tight.

This article was originally published in the Chicago Booth Review.