I decided to move this blog to Substack. My new address will be this: The Money Mischief | Kürşad Görgen | Substack
I moved to Substack
https://www.themoneymischief.com/i-moved-to-substack/
Brace for impact
2022 has been a year full of uncertainties for the global economy so far, and it looks like it will continue. Rising inflation, the invasion of Ukraine, and supply chain problems arising from China and Russia… None of this makes the Fed’s job any easier. But even before all this, the Fed had begun to have struggled in its monetary policy path. While the recent rate increase is one step towards solving this, it is not enough. War is a factor that will pour the uncertainty and the Fed seems to be struggling to find its way through all this.
There are two ways to think about current inflation. First, supply chain problems started with Covid-19 and worsened again with the invasion of Ukraine. It is not the Fed’s job to solve all this; moreover, that is well beyond its ability. You simply cannot expect the Fed to solve the problem in Ukraine. The Fed may take steps to offset the implications of supply chain problems as it did from early 2020 to mid-2021, but nothing more.
The second cause of inflation is directly linked to monetary policy – overexpansionary monetary policy. This is where things got complicated in mid-2021. When the Fed announced its new framework, FAIT, in 2020, it meant offsetting the previous undershoot with an overshoot to keep inflation at 2% over the long run. There was a lot of confusion about FAIT, some of which was the Fed’s miscommunication, the rest due to pundits’ failure to internalize the new framework. Still, the Fed did pretty well until mid-2021: the Fed should be praised for its achievements, such as the unprecedented rate of labor market recovery and the NGDP’s return to the trendline. But at the same time, supply chain problems persisted, and the Fed seemed somewhat reluctant to tighten monetary policy, even as NGDP reached its trend level.
Unfortunately, this was the cause of the problem after mid-2021. Indeed, given the Fed’s framework, what they should have done simply was to start tightening monetary policy in the fall of 2021, as inflation had already reached the desired level, the labor market recovery is over, nominal wages were skyrocketing, and the NGDP had already exceeded its trend level. Although the Fed seems to have implicitly abandoned FAIT at this point, I have to admit that I believed in the new regime and had a good plan. Sadly, the Fed later abandoned FAIT entirely.

When we look at the TIPS spreads, we can clearly see that the Fed faces a major failure. Markets expect an extra 9% inflation throughout 2020, not an average of 2% inflation. This had to be a scenario that the Fed would not want and would not allow happen in any case. Worse, the abandonment of FAIT makes the conditions for a recession even more convenient and dramatically reduces the likelihood of the Fed making a soft landing.
Don’t get me wrong, I’ve supported FAIT and the Powell regime all the way through 2021, and I think their success is momentous. Bringing the labor market back to trend level is more than a miracle. However, some mistakes could destroy your previous achievements, and the Fed seems to be going that route.
One of the biggest mistakes that can be made is to attribute current inflation entirely to supply chain problems. While this was true until the fall of 2021, this is no longer the case. High inflation can sometimes have two causes, and we live in one of those unfortunate times. In the 1970s, there were oil shocks due to the war, and global wheat prices soared due to the Soviet Union. While we have similar supply chain issues today, all of that doesn’t explain the whole picture. Overexpansionary monetary policy is the cause of the problem. In 2008, the real problem was nominal; even though we are in the opposite scenario today, the real problem is still nominal. And it’s not just about raising interest rates. The Fed can raise interest rates at will, and still we can have high inflation and an overexpansionary monetary policy, which will cause a recession. The problem is the policy regime and its abandonment. This results in a fatal loss of credibility, and most of the things you do have no payoff.
The Fed needs to restore its credibility and tighten monetary policy urgently, not allowing supply chain issues to distract from its focus. A Fed that has lost its credibility will probably never even dream of a soft landing, and everything Powell’s Fed has accomplished will be meaningless. Of course, this is easier said than done. Bernanke’s inability to ease monetary policy sufficiently in 2008 may be due to something similar: the Fed has been institutionally reluctant to take certain steps. George Selgin noticed this, but the Fed seemed to have overcome it in 2020. Now we are going through the same thing all over again.
Everything that has happened in recent months seems to have made the Fed’s job very difficult, but I still think soft landing can be achieved. The rest will depend on Jay Powell’s talent.

https://www.themoneymischief.com/brace-for-impact/
The Long-Run Effects of Monetary Policy on Interest Rates
After reading Scott Sumner’s recent paper on the Princeton School of Macroeconomics and Zero Lower Bound, I revisited papers of other Princeton economists.[1]Sumner, Scott, The Princeton School and the Zero Lower Bound (October 2021). Mercatus Center Working Paper, https://www.mercatus.org/publications/monetary-policy/princeton-school-and-zero-lower-bound In the second part of the paper, Sumner discussed the Princeton School’s relationship with new schools of thought such as Market Monetarism and NeoFisherianism. In this regard, I examined how the work of the Princeton economists relates to some of the key ideas of market monetarism.
The Princeton School has many economists who have changed the course of macroeconomics. Almost everyone knows most of them today, whether they are familiar with macroeconomics. One of them is Refet Gürkaynak. I think his studies, examining the effects of monetary policy statements on markets and interest rates, should be one of the most significant studies in the field.
Refet S. Gürkaynak, Brian P. Sack, and Eric T. Swanson have a particularly interesting 2005 paper.[2]Gürkaynak, Refet S. and Sack, Brian and Swanson, Eric T., Do Actions Speak Louder Than Words? The Response of Asset Prices to Monetary Policy Actions and Statements, International Journal of Central … Continue reading As they write in the abstract:
We investigate the effects of U.S. monetary policy on asset prices using a high-frequency event-study analysis. We test whether these effects are adequately captured by a single factor—changes in the federal funds rate target—and find that they are not. Instead, we find that two factors are required. These factors have a structural interpretation as a “current federal funds rate target” factor and a “future path of policy” factor, with the latter closely associated with Federal Open Market Committee statements. We measure the effects of these two factors on bond yields and stock prices using a new intraday data set going back to 1990. According to our estimates, both monetary policy actions and statements have important but differing effects on asset prices, with statements having a much greater impact on longer-term Treasury yields.
The perspective that Gürkaynak et al. examine the effects of policy shocks is incredibly useful in evaluating monetary policy statements. Because, as Sumner argued in a recent paper, monetary policy works in two dimensions: by the changing levels of key macro variables and by the changing expected growth paths of these variables.[3]Sumner, Scott, A Critique of Interest Rate–Oriented Monetary Economics (November 2020). Mercatus Center Working Paper, … Continue reading Gürkaynak et al. show that the latter effect mostly comes from policy statements.
In another paper, Gürkaynak, Sack, and Swanson discuss the impact of surprise policy shocks on interest rates in the short and long term.[4]Gürkaynak, Refet S. and Sack, Brian and Swanson, Eric T., The Sensitivity of Long-Term Interest Rates to Economic News: Evidence and Implications for Macroeconomic Models, American Economic Review, … Continue reading The importance of this study is better understood after seeing their findings:
Since the federal funds rate has some persistence, as noted by many authors, tighter policy today leads to expectations that the federal funds rate will remain higher in the near future, thus pushing near-term forward rates in the same direction as the policy surprise. At longer horizons, however, forward rates actually move in the direction opposite to that of the policy surprise, i.e., a surprise policy tightening actually causes long-term forward rates to fall.
In fact, their findings seem consistent with market monetarism’s claim that interest rates can be a misleading indicator of the stance of monetary policy(see image below). The news in the media interpret a cut in the federal-funds target as easy money, and vice versa. Even worse, most of the resources you can find online fall into the fallacy of “reasoning from a price change” when defining monetary policy.
Partly, this mistake seems to stem from confusing the short-term and long-term. When interest rates change today, it simply shows the long-term response of interest rates to earlier actions taken by the Fed. Many of your comments about the monetary policy stance will be wrong if you ignore the long-term effects. A fall in nominal interest rates may indeed indicate easier monetary policy, but it may likewise be falling due to other factors.[5]Scott Sumner, The Money Illusion: Market Monetarism, the Great Recession, and the Future of Monetary Policy, The University of Chicago Press, 2021, 166-168.

It can be enlightening to think about the response of interest rates with the example of the Great Recession. Recall that the ECB tightened its monetary policy by raising interest rates in 2008. This caused the eurozone’s recession to deepen, and the consequences were catastrophic.[6]Politano, Joseph, The Great European Undershoot, Apricitas – an Econ Blog (blog), (August 7, 2021). https://apricitas.substack.com/p/the-great-european-undershoot What were the long-term effects of tight money? Lower income, lower inflation, and lower interest rates. If you want high rates over a long period, you must keep interest rates low for an extended period; the long-term response of interest rates will be the opposite direction, as Gurkaynak et al. have shown.
For the same reason, we can better interpret the Great Recession when we consider the cut in 2008 as the long-term response to the Fed’s previously unreasonable tight monetary policy. That’s what many people confuse: When the Fed cut the interest rates in late 2008, the media looked at it as the Fed eased the policy, not as the long-term effect of earlier tight money. If you think about it that way, it’s easy to believe that the Fed had nothing more to do, and it wasn’t Fed policies that triggered the recession. But when you look at it from a long-term perspective, the Fed should have worsened the financial crisis and triggered the Great Recession.[7]Halperin, Basil, Recessions Are Always and Everywhere Caused by Monetary Policy, Basil Halperin (blog), October 28, 2021. … Continue reading
Consequently, it seems quite misleading to interpret the stance of monetary policy by looking only at the changes in interest rates. Changes in interest rates may be due to other factors, or we may be seeing long-term responses. It’s wrong to draw conclusions about the stance of monetary policy without knowing why exactly rates have changed. That’s an essential point,[8]Sumner, Scott, The Dead Horse I’m Beating Is Very Much Alive, The Money Illusion (blog), October 3, 2021. https://www.themoneyillusion.com/the-dead-horse-im-beating-is-very-much-alive/because underestimating the long-term effects can cause a lot of confusion and mistakes, which has already triggered a recession a decade ago.
References
↑1 | Sumner, Scott, The Princeton School and the Zero Lower Bound (October 2021). Mercatus Center Working Paper, https://www.mercatus.org/publications/monetary-policy/princeton-school-and-zero-lower-bound |
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↑2 | Gürkaynak, Refet S. and Sack, Brian and Swanson, Eric T., Do Actions Speak Louder Than Words? The Response of Asset Prices to Monetary Policy Actions and Statements, International Journal of Central Banking, International Journal of Central Banking, vol. 1(1), (May 2005). https://ideas.repec.org/a/ijc/ijcjou/y2005q2a2.html |
↑3 | Sumner, Scott, A Critique of Interest Rate–Oriented Monetary Economics (November 2020). Mercatus Center Working Paper, https://www.mercatus.org/publications/monetary-policy/critique-interest-rate%E2%80%93oriented-monetary-economics-0 |
↑4 | Gürkaynak, Refet S. and Sack, Brian and Swanson, Eric T., The Sensitivity of Long-Term Interest Rates to Economic News: Evidence and Implications for Macroeconomic Models, American Economic Review, 95 (1): 425-436. (2005). DOI: 10.1257/0002828053828446 |
↑5 | Scott Sumner, The Money Illusion: Market Monetarism, the Great Recession, and the Future of Monetary Policy, The University of Chicago Press, 2021, 166-168. |
↑6 | Politano, Joseph, The Great European Undershoot, Apricitas – an Econ Blog (blog), (August 7, 2021). https://apricitas.substack.com/p/the-great-european-undershoot |
↑7 | Halperin, Basil, Recessions Are Always and Everywhere Caused by Monetary Policy, Basil Halperin (blog), October 28, 2021. https://www.basilhalperin.com/essays/recessions-are-always-everywhere-caused-by-monetary-policy.html |
↑8 | Sumner, Scott, The Dead Horse I’m Beating Is Very Much Alive, The Money Illusion (blog), October 3, 2021. https://www.themoneyillusion.com/the-dead-horse-im-beating-is-very-much-alive/ |
https://www.themoneymischief.com/the-long-run-effects-of-monetary-policy-on-interest-rates/
Sticky Wages: The Key Problem of Macro
The reason we worry about recessions is mostly involuntary unemployment. Because recessions cause employment fluctuations, and this affects the entire economy. But, why do recessions cause employment fluctuations? Indeed, this question is one of the most important questions at the heart of macroeconomics, and it shows us why nominal variables and wage stickiness is so important in recessions.
A useful way to distinguish shocks that affect the economy is to classify them as nominal and real shocks. Real shocks include the natural employment rate, technology shocks, taxes, and similar types of variables. Real shocks are particularly important when prices and wages are relatively flexible. If we lived in a world where all wages are perfectly flexible, nominal variables would be almost unimportant in this sense, and real variables would be enough to explain business cycles. Alas, that’s not the case, and it’s exactly what makes sticky wages the key problem.
The diagram below is from Scott Sumner’s new book, The Money Illusion.[1]Sumner, S. (2021). The Money Illusion: Market monetarism, the Great recession, and the Future of Monetary Policy. p. 29. The University of Chicago Press. I like to think about business cycles and macroeconomics with this diagram. Because it helps us better understand why changes in nominal variables have real effects.

Money is neutral in the long run but strongly non-neutral in the short run, so monetary shocks affect real wages, output, employment in the short run.[2]Sumner, S. (2021, September 29). Money neutrality, super-neutrality, and non-neutrality. Retrieved October 11, 2021, from https://www.econlib.org/money-neutrality-super-neutrality-and-non-neutrality. Therefore we can talk about the real effects of a change in nominal variables in the short run. However, it’s a little more difficult to explain why a change in nominal variables has real effects. I’ll show you that it’s mostly because of sticky wages. In my opinion, sticky wages are key to understanding business cycles and macroeconomics overall. But Kursad, why? Note that the recessions are caused by sharp declines in NGDP growth. Nevertheless, this itself does not explain why changes in the NGDP growth rate are so important, or why and how it relates to sticky wages. To understand the importance of NGDP shocks, we need to examine the nominal variables; and to understand that, we need to look at sticky wages closely. When economists talk about wage stickiness, what they usually mean is nominal wage stickiness. Because nominal wages are slow to adjust, this affects employment when the economy suffers a shock.
I will first explain why sticky wages matter, then explain why I prefer to focus on sticky wages rather than sticky prices.
Let’s start with a small-scale example to see how sticky wages work. Assume that the demand for refrigerators is unit elastic. For some reason, people are willing to spend more money on refrigerators than in previous years. This shifts the demand curve to the right, but that does not necessarily increase the number of refrigerators sold. In the case of full employment, this only causes wages and employment to rise, and refrigerator manufacturers simply increase the price per unit of the refrigerator. Nevertheless, if NGDP growth rates are low, wages will react to it, and we expect them to be highly sticky. In such a case, refrigerator manufacturers will likely respond to the change in demand by selling more refrigerators. Sticky wages aren’t the only reason for that, but it’s one of the most important reasons.
The evidence that wages are sticky in the short run is so obvious that I’ll take it as given. Instead, let’s look at a few ways to think about sticky wages. The conventional method of thinking about sticky wages is W/P. I think this works well in certain circumstances and not in others. For example, W/P will work well if the refrigerator industry is perfectly competitive. The MC curve shifts upward less than the demand curve, and output increases, so prices will increase, and W/P will fall. This would be a classic sticky wages scenario that leads to countercyclical real wages. But in a monopolistic competitive industry, for example, W/P will not work that well. A scenario in which neither wages nor prices will increase is likely, or both may increase very slightly and at similar rates. In such a case, W/P would be roughly the same, making it very difficult to explain business cycles in terms of W/P.
I think W/NGDP is much more useful than W/P. Nominal hourly wages are sticky, so it’s natural to expect hours worked to fall when nominal spending falls. W/P and W/NGDP are actually unrelated phenomena. Both stickinesses exist, but the key macroeconomic problem is nominal wage stickiness. On the other hand, microfoundations won’t help you beyond this point. The key is aggregate wage stickiness; it would be misleading to think about specific industries or firms. Suppose Saber Steel laid off a large number of workers in a recession. Saber Steel would have done this not because wages were sticky in the steel manufacturing industry but because wages were sticky in other markets or industries. Because wages outside of the steel industry are sticky, a reduction in total labor compensation leads to fewer hours worked. People or firms will buy less steel during a recession, but many everyday purchases will remain roughly the same. Thus, in a recession, for example, Burger King employees or cashiers are less likely to lose their jobs, while steelworkers are more likely to lose their jobs.
So far so good, but even if we agree that wage stickiness is matters and W/NGDP is more useful than W/P, why should we focus on wage stickiness and not price stickiness?
Basil Halperin argues here that it was a big mistake to switch from models of wage stickiness to models of price stickiness:[3]Halperin, B. (2021, June 16). It was a mistake to switch to sticky price models from Sticky Wage Models. Basil Halperin. Retrieved October 11, 2021, from … Continue reading
The history of thought here and how it has changed over time is interesting on its own, but it also suggests a natural conclusion: if you think of involuntary unemployment as being at the heart of recessions, you should start from a sticky wage framework, not a sticky price framework. The original empirical and conceptual critiques of such a framework were misguided.
The debate over wage vs. price stickiness first caught my attention almost five years ago. Although I thought price stickiness was quite important back in those days, I have to admit that I didn’t care much about wage stickiness(but I was a 15-year-old teenager, so it can be forgiven). But after reading the article by Scott Sumner and Steve Silver, my views started to change. Silver and Sumner found in their study that wages are cyclical when the economy is hit by supply shocks, and highly countercyclical when hit by demand shocks.[4]Sumner, S., & Silver, S. (1989). Real Wages, Employment, and the Phillips Curve. Journal of Political Economy, 97(3), 706–720. http://www.jstor.org/stable/1830462.
As I said, I didn’t care about wage stickiness back then. But at some point, I began to question whether inflation was a good variable for our models. A huge part of CPI is rent equivalent, so how can our models explain fluctuations in employment in this way? While there are more issues with the CPI, this was not the main problem that concerned me. NGDP is more of a “real” thing; It’s not just the sum of RGDP and inflation, it has real effects.
Let’s start with a simple question. In the long run, do wages track NGDP/person or inflation? If you think the answer is the latter, you cannot explain the relationship between rising wages and (relatively) low inflation. Despite having a similar inflation rate to the US, China has rapid nominal wage growth. NGDP/person growth drives up wages. And that’s exactly where this problem becomes different from the rest of the economics. We know that NGDP fluctuations are erratic, and nominal wages are slow to adjust; that’s why W/NGDP becomes countercyclical.
Mary Daly and Bart Hobijn created a labor market mathematical model in their work. The assumption lay on the model is that a given fraction of workers are resistant to wage cuts each year. The model also shows that the frequency of zero wage changes is highly correlated with the unemployment rate. Moreover, it explains why the recovery from the Great Recession has been slow. Daly and Hobijn found that productivity growth has the same effect as inflation in the labor market. I think NGDP growth is better than inflation in terms of the benefits of inflation. Here is another reason to prefer W/NGDP as NGDP growth is correlated with productivity growth+inflation.[5]Daly, Mary C, and Bart Hobijn. 2013. “Downward Nominal Wage Rigidities Bend the Phillips Curve,” Federal Reserve Bank of San Francisco Working Paper 2013-08. Available at … Continue reading
Indeed, one of the strongest arguments is the gradual weakening of the relationship between inflation and employment. The Phillips Curve has many weaknesses in this regard and it often misleads economists, as we saw the most recent example in 2019. In contrast, as Joey Politano shows, the Phillips Curve is especially strong from the private sector wages perspective because employment is more associated with wage growth than inflation.
So, what’s my solution? Going back to the basic models such as AS/AD, because it’s much simpler and more useful. Let’s go back to what we were concerned with in the first place, unemployment. The AS/AD model was developed to explain fluctuations in employment. So the first thing we’ll look at is the labor market. And everything becomes clearer when we look at it. Hours worked move in the same direction as NGDP.[6] Sumner, S. (2021). The Money Illusion: Market monetarism, the Great recession, and the Future of Monetary Policy. p. 151-154. The University of Chicago Press.

To summarize, 1) recessions and employment fluctuations are highly correlated, 2) nominal shocks have real effects, 3) hourly wages closely follow NGDP/person, 4) when the economy is hit by a negative nominal shock W/NGDP becomes highly countercyclical because nominal wages are sticky 5) W/NGDP is especially useful in explaining employment fluctuations, hence the recessions.[7]Sumner, S. (2019, January 20). Are recessions about employment?. Retrieved October 3, 2021, from https://www.themoneyillusion.com/are-recessions-about-employment.
All of this may not lead us to NGDP targeting. A framework like GLI targeting is also possible, which is extremely attractive and will stabilize employment fluctuations similarly.[8]Amarnath, S. (2019, May 18). Floor It! Fixing the Fed’s Framework With Paychecks, Not Prices. Retrieved September 23, 2021, from … Continue reading But from a W/NGDP perspective, regardless of policy implication, it’s clear that sticky wages almost always better explain fluctuations in employment.
References
↑1 | Sumner, S. (2021). The Money Illusion: Market monetarism, the Great recession, and the Future of Monetary Policy. p. 29. The University of Chicago Press. |
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↑2 | Sumner, S. (2021, September 29). Money neutrality, super-neutrality, and non-neutrality. Retrieved October 11, 2021, from https://www.econlib.org/money-neutrality-super-neutrality-and-non-neutrality. |
↑3 | Halperin, B. (2021, June 16). It was a mistake to switch to sticky price models from Sticky Wage Models. Basil Halperin. Retrieved October 11, 2021, from https://www.basilhalperin.com/essays/sticky-prices-vs-sticky-wages.html. |
↑4 | Sumner, S., & Silver, S. (1989). Real Wages, Employment, and the Phillips Curve. Journal of Political Economy, 97(3), 706–720. http://www.jstor.org/stable/1830462. |
↑5 | Daly, Mary C, and Bart Hobijn. 2013. “Downward Nominal Wage Rigidities Bend the Phillips Curve,” Federal Reserve Bank of San Francisco Working Paper 2013-08. Available at https://doi.org/10.24148/wp2013-08. |
↑6 | Sumner, S. (2021). The Money Illusion: Market monetarism, the Great recession, and the Future of Monetary Policy. p. 151-154. The University of Chicago Press. |
↑7 | Sumner, S. (2019, January 20). Are recessions about employment?. Retrieved October 3, 2021, from https://www.themoneyillusion.com/are-recessions-about-employment. |
↑8 | Amarnath, S. (2019, May 18). Floor It! Fixing the Fed’s Framework With Paychecks, Not Prices. Retrieved September 23, 2021, from https://medium.com/@skanda_97974/floor-it-fixing-the-feds-framework-with-paychecks-not-prices-78171423e9c1. |
https://www.themoneymischief.com/sticky-wages-the-key-problem-of-macro/