What Lit the Fuse?

After two decades of low and stable inflation around 2%, the post-Covid recovery triggered an inflationary surge not seen since the 1970s. Inflation peaked at 9.1% in the United States (June 2022) and nearly 11% in the euro area (October 2022), before gradually returning toward target levels by late 2023.

From the outset, labor market dynamics played a central role in both policy and academic debates. Was this inflationary spike driven by labor market tightness — and if so, which mechanisms were at play? Or did rising inflation itself shape the evolution of the labor market?

At the heart of these questions lies labor market tightness, typically measured by the ratio of job vacancies to unemployed individuals (the V/U ratio). This indicator underpins two foundational macroeconomic relationships. The Beveridge curve captures the inverse link between unemployment and vacancies: during expansions, firms post more vacancies to meet growing demand, reducing unemployment and raising tightness. The Phillips curve, in contrast, links tightness to inflation: as demand increases and labor markets tighten, firms must offer higher wages to attract workers — raising labor costs and, ultimately, prices.

Both curves can shift due to supply-side or structural factors. For instance, if vacancies become harder to fill — due to skills mismatches, increased resignations or reduced labor force participation — tightness can rise even with stable unemployment. Similarly, inflation may increase for a given level of tightness if supply disruptions push up costs.

Within this framework, three competing narratives have emerged to explain the link between inflation and labor market conditions.

Supply-side shocks triggered inflation; tightness kicked in later

Inflation initially surged due to a confluence of shocks: supply chain disruptions, a shift in consumer spending from services to goods, the reopening of economies after pandemic lockdowns and large-scale fiscal stimulus. These forces simultaneously strained supply and boosted demand, creating sharp imbalances. Central to this narrative is the view that supply-side pressures — particularly sector-specific bottlenecks — were the initial trigger. Prices rose markedly in key sectors without offsetting declines elsewhere, driving up aggregate inflation and shifting the Phillips curve upward.

As the recovery gathered pace, aggregate demand continued to strengthen, prompting firms to expand hiring. Vacancy postings surged, increasing labor market tightness and exerting further upward pressure on wages and prices along the Phillips curve. On the Beveridge curve, rising vacancies reduced unemployment.

But the labor market was still coping with the effects from the pandemic: job matching became more difficult as many workers had exited the labor force or were reluctant to return to pre-pandemic jobs that they no longer found attractive. As a result, firms had to post more vacancies to achieve the same level of unemployment, effectively shifting the Beveridge curve outward. The result was a labor market characterized by persistently high tightness, even as unemployment remained relatively stable.

Tightness caused inflation

This second view holds that labor market tightness was the primary driver of inflation from the outset. It challenges the then-prevailing notion of a flat Phillips curve — namely, the idea that tight labor markets had little influence on inflation. Instead, it contends that when tightness reaches exceptionally high levels, its inflationary effects reassert themselves, effectively steepening the Phillips curve.

According to this perspective, the post-pandemic surge in demand — driven by reopenings and unprecedented fiscal packages — led to acute labor shortages. Firms, unable to expand output sufficiently, responded by raising wages more aggressively than in normal times and passed the resulting cost increases on to consumers. In this interpretation, tightness re-emerged as a powerful inflationary force, reviving the tightness–inflation link and amplifying the effects of ongoing supply shocks.

Inflation caused tightness

A third view turns the story on its head: it was not labor market tightness that caused inflation, but rather inflation that fueled labor market tightness. In this narrative, the elevated V/U ratio — typically a signal of strong labor demand — may instead reflect how workers responded to rising prices.

Initially, many workers tolerated higher inflation due to the frictions and costs associated with renegotiating wages or changing jobs. But as inflation persisted, a growing number began to seek better-paying jobs or push for higher wages. Survey evidence confirms that workers actively responded — particularly through on-the-job search — to protect their purchasing power. Notably, the wage growth gap between job movers and job stayers widened significantly during this period, making job switching especially attractive.

This surge in on-the-job search led firms to post more vacancies aimed at attracting already-employed workers. As a result, vacancy rates rose without necessarily reducing unemployment — effectively shifting the Beveridge curve outward. From this perspective, inflation created the illusion of a tight labor market — raising the V/U ratio without actual overheating.

The labor market has been central to understanding the causes and dynamics of the 2021–2023 inflation surge. While macroeconomic indicators have supported divergent narratives, micro-level data — particularly on the wage behavior of job switchers versus stayers — offer a sharper lens for identifying the forces at play. As new data continue to emerge, our understanding of the tightness–inflation relationship will no doubt evolve — possibly leading to significantly different policy implications.