Inflation risk and the labor market: beneath the surface of a flat Phillips curve

BIS Working Papers  |  No 1054  | 
22 November 2022



After the Great Financial Crisis, the labour market's influence on inflation decreased, largely due to anchoring of expectations and workers' reduced bargaining power. This paper studies whether perceived inflation risk, as gauged from inflation options, was more attuned to employment conditions. That is, did a tight labour market raise the perceived likelihood that inflation could overshoot expectations, even as realised inflation stayed subdued?


I study the link between labour market tightness and investors' perceptions of future inflation rates and of inflation risk. The methodology is very similar to the traditional Phillips curve framework, making the results easier to interpret. I also discuss why the prices of inflation options, which are often used to gauge inflation risk, are informative despite their illiquidity. To further prove the usefulness of inflation risk measures, I link them to future patterns in wage growth and in market-based inflation expectation.


The perceived risk of higher inflation rises as the labour market tightens, even if realised inflation remains subdued. The link is particularly strong if unemployment is already unusually low, pointing to significant non-linearity in the relation between inflation risk and labour conditions. Measures of inflation risk convey useful information, as shown by their ability to anticipate, first, patterns in wage growth across industries and, second, realised moments of market-based inflation expectations.


While the Phillips curve appeared quiescent after the Great Financial Crisis (GFC), inflation risk, as gauged from option prices, remained sensitive to employment dynamics. Using Phillips-curve regressions centered on option-implied moments, I show that, in tight labor markets, a fall in the unemployment gap raises the risk that inflation overshoots expectations – even if realized and expected inflation remain stable. In tight labor markets, implied moments convey valuable information, as shown by their ability to anticipate future patterns in inflation breakevens and wage growth. The usefulness of inflation options in assessing risk, despite their illiquidity, is rooted in reputational incentives that dealers have to disseminate accurate quotes.

JEL classification: G12, G14, G23

Keywords: inflation expectations, inflation risk, inflation options, labor market