US unemployment set to rise

Believe it or not – one of my favourite books on the Great Depression is not about monetary policy, but rather wage stickiness in the US labour market and failed labour market policies during the Roosevelt administration. The book is Richard Vedder and Lowell Gallaway’s “Out of Work: Unemployment and Government in Twentieth-Century America”.

A key conclusion in Out of Work is that real wages are strongly countercyclical when the economy is hit by aggregate demand shocks. The mechanism is simple. When a negative demand shock hits the economy the aggregate demand curve shifts to the left causing a drop in inflation (expectations) and as nominal wages typically are stickier than prices this will cause real wage growth to increase. This is in turn will cause unemployment to rise.

This essentially means that there are two elements in the sharp rise in US unemployment during the Great Depression – first of all a monetary contraction and second of all sticky nominal wages. Said in another way the reason US unemployment rose during the Great Depression was the fact that nominal wages failed to drop as much as prices was nominal wages where downward sticky.

In fact, the Roosevelt administration did a lot to curb the necessary downward adjustment of nominal wages for example through first of all the National Industrial Recovery Act (1933) and later that Wagner Act (1935) and the Wage-Hours Act (1938).

Scott Sumner tells exactly story in his new book The Midas Paradox – The Great Depression had two legs: A monetary policy shocks (the negative AD shock) and the government policies to push up nominal wages growth (the negative AS shock).

Repeating history – strongly countercyclical real wage growth post-2008

If we look at what have happen on the US labour market from 2008 the story in many ways is similar to what happened during the Great Depression.

The graph below illustrates this.

Real wages

When the negative aggregate demand shock – the monetary contraction – hit in 2008 inflation expectations – here illustrated by 5-year/5-year inflation expectations – dropped dramatically. As nominal wages are sticky they failed to drop as much as inflation expectations initially, which in turned caused a sharp rise in real wages. This is the counter-cyclicality of real wages – a negative demand shock causes a rise in real wages. This resulted in a sharp increase in US unemployment in 2008-2009.

However, as the Federal Reserve moved to offset the initial shock inflation expectations rebounded in early 2009, which in turn cause real wage growth to start slowing and as a result US unemployment started to decline from October 2009 – essentially with a six-month lag from when real wage growth again had dropped below the pre-crisis average around 1.5%. Hence, again we see a strong counter-cyclicality – as the Fed moves to boost aggregate demand growth real wages decline, which in turn caused unemployment to drop.

Extremely lacklustre real wage growth       

While the Fed initially moved to offset the initial aggregate demand shock the Fed effectively failed to move nominal aggregate demand growth back to the old growth of 5-5½% nominal GDP growth and rather seems to implicitly has targeted less than 4% NGDP growth since 2009.

As a result, both nominal and real GDP growth have been extremely lacklustre since 2009 and even if we have assumed that the there is a “great stagnation” in US productivity growth (which I really don’t think is the case) then real wage growth has been extremely meagre. This undoubtable is a reflection of the fact that monetary conditions have remained excessively tight since 2009.

However, this also illustrates that nominal wages are not sticky in medium-to-long run and one can hence, conclude that unemployment has come down in the US not only because of Fed monetary easing – in fact monetary policy seems to have been continuously too tight – but rather because the aggregate supply curve has shifted rightwards causing nominal and real wage moderation.

On the positive side even though there have been some political attempts in the US to push up wage growth for example through legislation to increase the minimum wage there measures implemented have been far less draconian and hence less damaging than what the FDR administration pushed through in the 1930s. As a result, we have seen more downward real wage flexibility in the US than was the case during the Great Depression. On the negative side the weak real wage growth in the recent is probably also an important cause of the rise of populist politicians like Donald Trump and Bernie Sanders.

Sharp rise in real wage growth will cause unemployment to rise

So while we during the period of moderate low (but stable) aggregate demand growth from 2010 to 2013-14 saw very weak nominal and real wage growth, which has caused the decline in unemployment the picture has changed rather dramatically since 2014.

Hence, I have earlier argued that the Federal Reserve essentially from mid-2014 has moved to tight US monetary conditions rather significantly (David Beckworth has made a similar point – see for example David latest blog post here).

The tightening of US monetary condition has been very visible inflation expectations, which essentially have been trending downwards for nearly two years.

While nominal wage growth has been fairly low and stable the drop in inflation expectations means that over the past year or so have seen a gradual acceleration in real wage growth.

Paradoxically while is in fact is an indication that US monetary policy becoming too tight and the unemployment likely soon will start to rise Fed Chair Janet Yellen sees rising real wage growth as an indication that inflation soon will rise.

The problem obviously is that Yellen fail to realize that inflation is a monetary phenomena and that real wage growth is counter-cyclical rather than pro-cyclical. As a consequence Yellen seems to completely miss the fact that her overly tight monetary stance is pushing the US economy closer and closer to recession. Some thing also visible is the US yield curve, which has been flattening significantly recently and if Yellen’s Fed continues to insist on interest rate hikes then it becomes very likely that the yield curve will turn inverse – 10-year yields will drop below 2-year yields. That would be a very clear signal that the US is heading for another Fed-induced recession.   

Or as Rudi Dornbusch once said:

“No postwar recovery has died in bed of old age—the Federal Reserve has murdered every one of them.”

Unfortunately, the Fed seems overly eager to prove Dornbush right again.

Leave a comment


  1. William

     /  March 10, 2016

    Excellent post Mr. Christensen

    What do you make of today’s ECB announcement? — especially by the fact that the euro first fell and then rose sharply and that the general consensus seemed to have been that it was largely unexpected.

  2. numawan

     /  March 11, 2016

    I agree with your overall line of reasoning, but I have two comments.

    First, you seem to compare actual nominal wage growth with the 5y5y forward inflation expectations. That does not look very clean to me. I would rather compare actual nominal wage growth with actual inflation. Of compare some kind of forward looking measure of wage growth (but that probably does not exist) with forward looking inflation.

    Second, you seem to imply that any kind of real wage growth will lead to an increase of unemployment. Probably not. The economy can probably accommodate a moderate level of real wage growth without negative effects on employment.

  3. Regarding your statement that there has been monetary tightening since mid-2014 you may be interested in the graph on which shows that there has been a relative monetary tightening since January 2014. By relative I mean that although money supply has not fallen, the YoY rate of growth has slowed down.

    I believe, counterintuitively, that the initial effect of the Fed’s decision to raise interest rates will be a rise in inflation. See the three graphs on

    They show that when the Fed Funds Rate is raised from very low levels the effect is a rise in inflation. In the recent past many commentators have sought an explanation in the Fisher equation. In my opinion, the real reason is quite simple. Very low interest rates favour the financial sector. When interest rates are raised, even in a situation of monetary tightening, money moves out of the financial sector and into the real economy.

    I too believe that a recession is likely, but as in the Great Recession, it will be caused and preceded by a major market crash.

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