Slack and prices during Covid-19: Accounting for labor market participation

Strong labor force participation cyclicality during the Covid-19 pandemic has put further into question the capacity of standard Phillips Curve (PC) models to fully capture labor market cyclical conditions. In this paper, we jointly estimate natural unemployment and participation rates (i.e. compatible with constant inflation) through an augmented PC informed by structural labor market flows across employment, unemployment and inactivity. Focusing on Italy we find that, during the pandemic: (i) natural unemployment has remained unchanged, while natural participation has declined slightly, mostly due to a rise in retirement flows driven by a temporary reduction in pension eligibility rules; (ii) virtually all slack was accounted for by the participation margin, which added significant downward pressures to inflation dynamics.

Automated summary

The strong fluctuations in labor force participation during the Covid-19 pandemic have raised doubts about the accuracy of standard Phillips Curve models in capturing labor market conditions. This paper proposes an augmented Phillips Curve model that incorporates structural labor market flows and estimates the natural unemployment and participation rates. The findings for Italy show that the natural unemployment rate remained unchanged, while the natural participation rate slightly decreased, mainly due to an increase in retirement flows.