Summary.    The Federal Reserve is hiking interest rates to fight inflation, and looking at measures of the labor market to see how it’s doing. When the labor market has very little slack—when there aren’t many workers looking for jobs—inflation tends to rise. But...

The Federal Reserve raised interest rates by another .75% last week, the latest in a series of rate hikes designed to tame inflation. The question looming over the economy now is whether the Fed has gone too far or not far enough. The answer depends on how much slack there is in the labor market. The Fed would like to see labor markets with enough slack that wage growth moderates to a level consistent with their 2% inflation target. But how do we assess the current degree of slack?

A new, broader measure of labor market tightness, that we created using data from LinkedIn, provides a new way of answering that question. And it suggests labor markets aren’t as tight as other metrics indicate. That, in turn, suggests the Fed may be at risk of raising rates too quickly. 

The idea of “slack” in the labor market refers to the shortfall in employers’ demand for labor relative to the available supply of workers. When there are very few workers available, wages get bid up quickly as companies boost pay to hold onto workers and hire new ones. As the cost of labor goes up, companies in turn raise prices to pass on their higher costs to consumers. Consumers then ask for raises from their own employers so they can afford the higher cost of living, perpetuating the inflation cycle. For that reason, economists see at least some amount of unemployment as necessary for keeping prices stable. A little slack in the labor market keeps inflation at bay.  

To measure labor market slack, economists have long relied on the number of job openings divided by the number of unemployed people. Evidence suggests that this ratio outperforms the traditional unemployment rate when it comes to forecasting inflation. A higher ratio of job openings to unemployment makes it more challenging for employers to find workers and easier for workers to find jobs, thus indicating that the labor market is tighter. The ratio of job openings to unemployment is over 1.85 today, suggesting that there are nearly two job openings for every unemployed individual looking for a job. This ratio is considerably higher than its pre-pandemic level and higher than the historical norm of about 0.7 since 2000. 

But if the job openings to unemployment ratio is indicative of a very tight labor market, then why does real wage growth continue to be so tepid? One potential reason for this anomaly is that the labor market is not actually that tight — that is, the standard measures of slack might not be telling the whole story. There may be several reasons why the conventional measure may be a poor proxy for the degree of labor market tightness. For example, when looking to hire workers, employers often do more than post a job vacancy. They can alter their hiring standards for a given position by adjusting specific requirements for a particular job, or they can fill their positions faster by varying the amount of resources they dedicate to recruiting. Hence, simply looking at job openings may be problematic. Existing evidence suggests that the intensity with which employers fill their job openings varies over the business cycle. That is, employers tend to put in the most effort into filling their vacancies when the economy is expanding and less during downturns and in times of economic uncertainty. 

Another reason the traditional economic metric may fail to capture the true degree of labor market tightness is that the number of unemployed people may be a poor proxy for the availability of workers to fill vacant jobs. For example, many applicants to job openings are already employed. Yet the standard metric does not take this into account. Thus if there is a significant number of these workers, then the standard metric would overestimate the tightness of the labor market. Indeed, LinkedIn’s data on active job seekers suggest this to be the case.  

In the figure below, we plot the traditional measure of labor market tightness, the ratio of job openings to unemployment (the green line). We also plot LinkedIn’s broader measure of tightness calculated using LinkedIn’s ratio of active job openings to active job seekers (the blue line). This more nuanced measurement of active job openings takes the variation in employers’ recruiting efforts into account and then looks at how the number of active job openings compares to the number of active job seekers on the platform. This broader perspective on the labor market tightness allows us to assess the health of the labor market more comprehensively than has been done before. In October 2022, LinkedIn’s metric indicates the ratio of active job openings to active applicants on LinkedIn was around 1.0, suggesting that there is a job available for every active job seeker in the United States.  

LinkedIn’s Labor Market Tightness metric is calculated as the number of active job openings posted directly on LinkedIn divided by the total number of active applicants. Active applicants are members who submit at least one application to a job opening in a given month. We measure active job openings as the stock of open job positions on the last business day of the month multiplied by an index of recruiting intensity. The idea behind recruiting intensity is to measure how actively employers are looking to fill vacant jobs. To quantify that, we follow the method developed by Steven J. Davis, R. Jason Faberman and John Haltiwanger (DFH) — the key idea is that a slack labor market makes it easier for employers to hire in general, so less recruiting effort is required to achieve the same hiring rate.   

The analysis suggests that the labor market did not tighten as much during the pandemic as implied by the conventional job openings to unemployment ratio.  

What difference does it make, from a policy perspective, if the labor market is less tight than it appears? 

If the standard measures of labor market slack are not capturing all those who are actively looking for work, then a smaller monetary tightening would be appropriate — in other words, interest rates don’t have to go up too rapidly. Fighting inflation can be a lot like driving on a congested highway. Braking too hard can increase the risks of an accident and therefore can result in not just a slowdown but an economic recession. In our estimation, as it stands right now, the U.S. labor market is still running hot relative to the pre-pandemic baseline, with job openings and quits on LinkedIn still elevated and unemployment at its lowest levels. But monetary policy works with a substantial lag. It takes time for monetary tightening to reduce demand. Hence, it is no surprise that the recent Fed tightening hasn’t had much impact on inflation yet. In this highly uncertain environment, striking a balance between containing potential threats of inflation and avoiding a disorderly tightening of financial conditions will be critical.