Commentary on Political Economy

Wednesday 14 September 2022

The Fed must avoid Volcker’s inflation error

Frederic Mishkin

Paul Volcker is considered to be a Goat (greatest of all time) central banker as he and the US Federal Reserve broke the back of inflation in the early 1980s. However, less talked about is the serious policy mistake the Volcker Fed made in 1980. The result was a more prolonged period of high inflation that required even tighter monetary policy, which then resulted in the most severe US recession since the second world war up to that time.

There are many parallels between the current situation of Jay Powell’s Fed and what happened then, so it is imperative we learn from history to avoid repeating the error.

By the time Volcker became Fed chair in July 1979, the central bank’s credibility on inflation had been destroyed by the disastrous policies of the previous chairs, Arthur Burns and G William Miller, with inflation climbing to more than 12 per cent by October 1979.

At a surprise press conference on October 6 1979, Volcker announced that the Fed would allow the benchmark federal funds rate to “fluctuate over a wider range”. The federal funds rate climbed to more than 17 per cent by April 1980.

Pressure on the Fed to reverse these rate increases began to build, with farmers blockading the Fed headquarters in Washington with their tractors and car dealers sending car keys in little coffins to the Fed. Politicians of both parties then piled on and strongly urged the Fed to scale back interest rates.

With the unemployment rate rising by more than a percentage point to more than 7 per cent in May after a recession began, the Fed decided to reverse course and sharply lower the federal funds rate by more than 7 percentage points. This action was taken despite the fact that inflation reached a peak of 14.7 per cent in April.

The Fed had blinked and Volcker’s credibility as an inflation fighter took a hit. Inflation expectations stayed stubbornly high and actual inflation remained above 12 per cent through to the end of 1980.

With the recession ending in July 1980, the Fed got back into the inflation fighting business and started to raise the federal funds rate again. But this time, to re-establish its credibility, the Fed had to raise the federal funds rate to a crushing level of nearly 20 per cent by the middle of 1981. Volcker finally had the courage to take out the baseball bat to slam the economy and slay inflation. The ensuing recession that started in July 1981 became the most severe downturn since the second world war.

Only after clobbering the economy, and keeping the federal funds rate near 15 per cent until the middle of 1982, did inflation expectations and the inflation rate start a steady, but slow, decline to about the 3 per cent level in 1983.

This review of history tells us that the loss of credibility from reversing policy before the inflation task was completed required much higher interest rates and a far larger cost to the economy of lost output and high unemployment than if the Volcker Fed had stuck to its guns.

There are many parallels to what happened during 1979-82 with what the Fed is facing now. The Fed’s credibility to keep inflation under control was weakened by its policy mistakes, abandoning a pre-emptive policy to control inflation in 2021 and the flawed execution of a new strategy framework targeting an average inflation rate in late 2020.

The Fed has now appropriately reversed course and is raising the federal funds rate at the fastest pace for more than 40 years. The Fed’s loss of credibility, I think, will lead it to raise rates much more than Fed projections or market forecasts suggest. The likelihood of a soft landing is therefore quite low and a recession is increasingly likely.

So far, the rhetoric from Powell and his colleagues is encouraging, with most of them saying that a recession will not deter them from keeping interest rates high until inflation is heading back towards the 2 per cent inflation target. However, it is easy to take this stance when the economy is doing well and when political pressure to lower interest rates remains moderate. This is likely to change when workers can’t find jobs and interest rates on mortgages and car loans rise even further.

When the going gets tough, the Powell Fed needs to stick to a plan of keeping interest rates sufficiently high for long enough to achieve their inflation objectives. It must continue to raise rates to uncomfortable levels and maintain them there.

The mistake that the Volcker Fed made in 1980 must not be repeated.

Frederic Mishkin is the Alfred Lerner Professor of Banking and Financial Institutions at Columbia Business School and is a former governor of the Federal Reserve

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