Scott Sumner  

Sticky wages and sticky fed funds rates

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Here's another post in my favorite theme, cognitive illusions.

Let's start with sticky wages, the easier concept. Suppose hourly nominal wage rates for many workers are renegotiated every 12 months. Also suppose the economy is in equilibrium and nominal wages are chugging along at 4% growth. Now assume that a shock comes along, such as falling NGDP. The equilibrium wage immediately falls, but each month only 1/12th of hourly workers renegotiate their contract. Thus the average wage rate will fall much more slowly than the equilibrium wage rate.

Paradox #1: Wages are most likely to be "too high" precisely when they are falling, and vice versa. This will confuse people, who will ask "how can sticky wages be a problem when wages are falling?" Sticky wages are a problem precisely when wages are falling (or rising), and are not a problem (ironically) when wages are not changing at all. That's why falling wages are correlated with recessions. Not because recessions cause wages to fall, but rather because falling wages are an indication that wages are still too high, creating unemployment.

Now let's consider sticky fed funds rates. This rate is targeted by the Fed, and adjusted every 6 weeks. Let's assume that policymakers are slow to respond to changing economic circumstances, and adjust the fed funds rate too slowly. This might reflect data lags, but I think there are other problems as well. In some cases that slowness to respond will result in major policy errors, which we might proxy by unstable NGDP.

Paradox #2: During periods when interest rates are falling, they will often be too high (but not always, as this is based on discretionary Fed errors, not the underlying nature of reality, as with sticky wages.) That is, monetary policy should be more expansionary during those periods when rates are falling (in most cases), and vice versa. I'm tempted to say that "interest rates should be falling even faster" but that's not quite right, as a more expansionary monetary policy would lead to a higher Wicksellian equilibrium interest rate, hence there would be less need to cut rates. But given the current Wicksellian rate, the target rate is often too high precisely when rates are falling.

And falling interest rates confuse people in exactly the same way as falling wages confuse people. People often see interest rates falling during a recession, and conclude that money is getting easier and that the recession is occurring despite the central bank's efforts. No, falling interest rates usually mean rates are too high, and getting increasingly too high. Tight money from the central bank is causing the recession, (unless it is a supply-side recession, with stable NGDP growth.)

These two cognitive illusions created Keynesian Economics, and continue to dominate the thinking of many modern macroeconomists. Most economists fully understand all the points made in this post, in theory. However due to powerful cognitive illusions, they have trouble recognizing these factors when looking at real world business cycles.

Market monetarists believe that monetary policy drives NGDP, which drives employment. Because we focus a lot on these two cognitive illusions, we are not discouraged by empirical data that others find to be inconsistent with the view that business cycles are usually caused by monetary shocks.


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COMMENTS (9 to date)
Kevin Erdmann writes:

Great post.

I think this is related to another illusion - that rising wages are inflationary. If Fed policy is sticky, then it will be pro-cyclical, and Fed policy will lead to inflation when a strong economy leads to rising real wages and interest rates.

The illusion is bolstered by the cognitive illusion of narrative thinking, where we imagine that employers and employees are in a negotiating battle and that rising wages are a result of employees having a stronger hand in negotiations.

But, rising wages aren't associated with falling profits.

But, this also is related to an illusion. Since profits are not sticky, they are the first measure to fall when a correction comes. When they begin to fall, it will naturally happen at the cyclical high point of wage growth and profit. So, if one is inclined toward believing the negotiating narrative, the empirical evidence will seem clear as a bell. Don't you see? Whenever real wages are growing at their highest, profits fall.

The narrative says that when a worker has readily available other options, he can go to his supervisor and demand a raise. This is why rising wages are associated with low unemployment.

But, the negotiation is a red herring. The real effect in that picture is that the worker has other opportunities, and that they are willing and able to move out of their current job into a job that captures more of their productive potential. It's the movement that creates the rising wage, not the negotiation. And, this is obvious in the JOLTS data.

This and a thousand other effects where frictions that keep labor from flowing freely to its best use are what keep real wage growth down when unemployment is high. Everybody is better off without the frictions. So, we see high real interest rates, high profits, and growing real wages together. The correlation of these sources of income is so overwhelming through business cycles, it's incredible that it is so universally misunderstood.

This is why it is so infuriating to me to see the "1% vs. 99%" rhetoric and the "corporations love to see high unemployment" rhetoric. Humanity has a special ability to use divisiveness in the service of ignorance. This is a case where the unifying truth is right in front of our noses, and so many people just aren't going to accept it.

Andrew_FL writes:

If wages neither fall in nominal terms, nor real terms, during a recession, but on the contrary, rise, as happened recently ("Average Hourly Earnings of All Employees: Total Private" or CES0500000003 at the St Louis Fed website rose from $21.21/hour in December of 2007 to $22.15/hour in June of 2009, which, based on the PCE index, is a rise from $23.47/hour to $24.16/hour in current dollars) this would seem to imply wages were, if anything, too low, even as unemployment was rising. An artifact of averaging? Did lower paid workers lose more jobs than higher paid workers?

Has that ever happened before?

Scott Sumner writes:

Kevin, Good comment, but I'd stay away from "real wages." Due to aggregate demand and supply shocks, there is no reliable relationship between W/P and the business cycle.

Andrew, The recent recession fits my model perfectly. Nominal wage growth slowed during the recession, but should have slowed much more sharply, given the steep fall in NGDP. Thus unemployment rose. Wages were too sticky, and hence W/NGDP rose sharply, as did unemployment.

Andrew_FL writes:

Oh okay so it's not that they needed to fall in absolute terms, necessarily, it's that they needed to fall relative to a trend.

I guess that makes sense, in much the same way as one judges the path of NGDP relative to a trend, as well.

Still, my concern was primarily that what might actually happen is that the composition of employment shifts, with losses primarily in lower paid positions. In which case the average would be misleading?

bill writes:

I think that Fed vanity exacerbates this. The Fed is so hooked on wanting their policy moves to be seen as consistent, that it seems to have forgotten that it's the economy (preferably NGDPLT, of course) that is what needs to be stabilized. We saw it in the mid 2000's when they raised the FF rate by a quarter point every meeting for like 17 meetings in a row. They were so afraid that if they missed a single meeting and then later went up a half, that they were "behind the curve" or something. And of course, lately, it was so important that once they started the taper that it absolutely had to taper by $10 billion per meeting. It's virtually the opposite of data driven. Even if they insist on using the wrong target, you'd hope they would be less concerned with someone writing that they were wishy-washy or behind the curve.

Kevin Erdmann writes:

You've probably answered this before. But how do you compare wage growth in a high inflation context with wage growth in a low inflation context if you don't use real wages.

I see decent real wage movement along with the business cycle and with the unemployment rate.

Prakash writes:

Good post, never thought that the confusion of rates with quantities may have been at the heart of keynesian economics. Definitely a new way to think about it.

Rajat writes:

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Scott Sumner writes:

Andrew, Yes, composition bias can create problems.

Bill, Good point.

Kevin, Real wages are not reliably pro or countercyclical. I prefer W/NGDP

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