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We assess the empirical relevance for inflation dynamics of accounting for the presence of search frictions in the labor market. The new Keynesian Phillips curve explains inflation as being mainly driven by current and expected future marginal costs. Recent empirical research has emphasized different measures of real marginal costs to be consistent with observed inflation persistence. We argue that, allowing for search frictions in the labor market, real marginal cost should also incorporate the cost of generating and maintaining long-term employment relationships, along with conventional measures, such as real unit labor costs. In order to construct a synthetic measure of real marginal costs, we use newly available labor market data on worker finding and separation rates that reflect hiring and firing costs. We then estimate a new Keynesian Phillips curve by generalized method of moments (GMM) using the imputed marginal cost series as an observable and find that the contribution of labor market frictions in explaining inflation dynamics is small.

The new Keynesian Phillips curve (NKPC) is at the heart of modern macroeconomic models that are used in the discussion and formulation of monetary policy. It is theoretically appealing in that it can be derived from first principles in form of an individual, forward-looking firm's price setting decision. Yet, at the same time, it preserves some of the flavor of more traditional Phillips-curve modeling. Empirical investigation of the NKPC faces two difficulties, however. First, the assumption of forward-looking expectation formation and the endogeneity of inflation and marginal cost render standard regression techniques problematic. Second, marginal cost as the explanatory variable for inflation dynamics is not readily observable to the econometrician. While marginal costs can be linked to observables, such as output, via the production function, these attempts have not proven to be entirely successful (Fuhrer and Moore, 1995, Roberts, 1995 and Roberts, 1997).

The main message in this paper is straightforward. Accounting for search frictions per se does not necessarily deliver a measure of real marginal cost that differs from the labor share, or unit labor costs. When estimating the NKPC using the imputed marginal cost series, the forward-looking component becomes only slightly more important compared to the standard model, while the responsiveness of prices to marginal cost changes is larger. Interestingly, whether we use direct measures of hiring activity or infer them from vacancies and unemployment via a matching function, does not make much of a difference.