Bank for International Settlements research proposes a flow-based unemployment gap to better signal inflation pressures

The Bank for International Settlements published a working paper introducing an “unemployment gap” based on labour market flows and showing it can improve predictions of US wage and price inflation relative to traditional slack measures. The paper argues that shifts in transitions between employment, unemployment and inactivity contain forward-looking information that static stock-based unemployment rates can miss. The unemployment gap is defined as flow-based unemployment implied by current transition probabilities minus observed (stock-based) unemployment. Empirically, a positive gap (flow-based unemployment above the stock rate) is associated with easing inflationary pressure, while a negative gap signals rising wage and price pressures. The authors find transitions into employment, including job retention and hiring rates, are the main drivers of the gap, and estimate that a gap widening consistent with a 1 percentage point rise in unemployment over the next 12 months is linked to a 1.3 percentage point decline in 12-month-ahead core CPI inflation. To rationalise the findings, the paper develops a search-and-matching model with nominal wage rigidities and persistent shocks in which firms’ wage-setting depends on both unemployment stocks and flows. The views expressed are those of the authors and not necessarily those of the BIS or its member central banks.