TAMING INFLATION: VOLCKER IN 1979 AND POWELL IN 2022

[Wagner Nolasco]

On Wednesday, September 21, 2022 at 2:00 pm, the Federal Reserve Bank raised short-term rates by 0.75% to fight inflation. The Fed’s benchmark interest rate is now between 3 percent and 3.25 percent.

The interest rate for a 30-year fixed mortgage rose to over 6 percent last week for the first time in 14 years according to Freddie Mac.

The Fed forecast the economy will grow 0.2 percent in 2022, down from its June forecast of 1.7 percent.

Here is how Paul Volcker tamed inflation when he was appointed Fed Chairman by President Carter in 1979 and reappointed by President Reagan in 1983. Fed Chairman Powell is a big fan of Volcker. Volcker’s approach may provide a blueprint for Powell:

“Paul Volcker became Chairman of the Federal Reserve Board on August 6, 1979. Volcker’s strategy involved letting interest rates rise in 1980-81 to levels unparalleled, then or since, and to become strongly positive in real terms. Fed funds rates rose to over 20%. Ten-year Treasury notes to over 15%. Thirty-year fixed rate mortgage rates rose to over 18%. The prime rate reached 21.5%.

The Volcker program triggered a sharp recession from January 1980, five months after he arrived, to July 1980, and then a very deep and painful recession from July 1981 to November 1982—“double dip recessions.” Both hit manufacturing, goods production, and housing particularly hard. In 1982, unemployment rose to 10.8%. The 1981-82 recession was the worst economic downturn in the United States since the Great Depression.

There were 69,000 business bankruptcies in 1982. The extreme interest rates wiped out savings and loan institutions by the hundreds.

The 1982 recession finally ended in November. Inflation in December 1982 was 3.8% year-over-year. The fed funds rate was 8.8%. The year 1982 also saw the start of the two-decade bull market in stocks, and the 40-year bull market in bonds.

When Volcker left office in August 1987, inflation was still running at 4%, far from zero, but far below the 13% of 1979 when he had arrived as Fed Chairman. Real GDP growth was strong; fed funds were 6.6%. “The Great Inflation was over, and markets recognized that it was over.” Endemic inflation, however, was not over.

A generation after Volcker, the Fed committed itself to perpetual inflation at the rate of 2% forever. At the 2% target rate, prices would quintuple in an average lifetime. That is obviously not the “stable prices” called for in the Federal Reserve Act, but the Fed kept assuring everybody it was “price stability.” Volcker made clear his disagreement with this 2% target, writing of it in 2018, “I know of no theoretical justification. … The real danger comes from encouraging or inadvertently tolerating rising inflation.”

The classic monetary theorist Irving Fisher had warned, “Irredeemable paper money has almost invariably proved a curse to the country employing it.”

“Nothing is more urgent than the United States getting its inflation under control,” he had already written in a formal Treasury presentation in 1969. “Inflation undermines trust in government,” Volcker said. In 1990, he commented “I think we are forced to conclude that even the partial victory over inflation is not secure.”

Volcker wrote that “Bill Martin [William McChesney Martin, Fed Chairman 1951-70]… is famous for his remark that the job of the central bank is to take away the punch bowl just when the party gets going.” Unfortunately, Volcker continued, “the hard fact of life is that few hosts want to end the party prematurely. They wait too long and when the risks are evident, the real damage is done”—then it is already too late and the problem has become a lot harder. Like now.’

Volcker and the Great Inflation: Reflections for 2022 | AIER