Remembering Paul Volcker, the man who tamed inflation

Paul Volcker, who passed away this week, was appointed to chair the Federal Reserve in August 1979, a pivotal moment in American economic history. His tenure – a unique blend of adaptability and fortitude – is one worth remembering. 

At the time, inflation had risen to double-digit levels and the public had lost confidence in the value of the U.S. dollar. Inflation hedges such as gold, collectables and art were increasing dramatically in value. Interest rates rose to over 15 percent as creditors sought to protect themselves from the loss in purchasing power of the money they lent out.

Economics textbooks sometimes portray the Great Inflation of 1966-81 as a supply side phenomenon. This is not the case, as total nominal spending (GDP) soared by roughly 11 percent per year between 1971 and 1981. This surge resulted in roughly 8 percent annual inflation and 3 percent real GDP growth. Had nominal GDP risen at a 5 percent annual rate, we would have had roughly 2 percent inflation and the same 3 percent real GDP growth during this period.

The problem was simple: too much spending caused by the Fed printing too much money. When interest rates are above zero, a rapid increase in the money supply is generally quite inflationary.

President Carter picked Paul Volcker to chair the Fed because of his reputation as an “inflation hawk,” someone willing to conduct a contractionary monetary policy, even if it were somewhat unpopular. After taking office, Volcker quickly got the Fed to push interest rates much higher.

In early 1980, the economy fell into a sharp downturn. The Fed then reduced interest rates, and the economy snapped back in the second half of the year. Unfortunately, inflation remained at double-digit levels into early 1981. Because the Great Inflation was seen as partly resulting from mid-20th Century Keynesian economic policies that had overstimulated spending, Volcker began considering alternative ideas being promoted by monetarists such as Milton Friedman.

Instead of relying on Keynesian policies such as interest rate targeting, Volcker had the Fed directly reduce the growth rate of the money supply, and let interest rates go as high as market forces dictated. By early 1981, the prime bank lending rate reached 20 percent. Once again, the economy fell into recession, with unemployment reaching a postwar high of 10.8 percent in late 1982.

But this time, the Fed continued with its restrictive monetary policies until inflation fell to roughly 4 percent, where it remained throughout the remainder of the 1980s. This victory over double-digit inflation occurred despite a big fiscal stimulus (tax cuts and defense spending) during the early years of the Reagan administration, which many pundits wrongly expected would lead to higher inflation.

Volcker’s tenure at the Fed didn’t just represent a revolution in policymaking, it also changed the way economists thought about the economy. Prior to Volcker, it was widely assumed that inflation was caused by specific “shocks” such as union wage demands, crop failures, budget deficits, medical costs and oil shortages. Relatively few economists believed that monetary policy was the culprit.

After Volcker, most economists accepted the idea that the Fed was responsible for keeping the rate of inflation low and relatively stable. This led to the idea of “inflation targeting,” which was formalized with an explicit 2 percent inflation target in 2012, although the Fed had already informally adopted the idea several decades earlier. 

Today, there is a real danger that the insights of the Volcker era will be lost. An increasing number of economists favor the use of fiscal policy to stabilize the economy, despite abundant evidence that monetary policy is far more effective. Volcker brought inflation down by getting the money supply under control, whereas recent Fed policy is moving back toward emphasizing control of interest rates. But one cause of the Great Inflation was the misuse of interest rate targeting — the failure to recognize that high interest rates do not necessarily represent tight money. Interest rates often reflect the condition of the economy, not monetary policy.

Volcker showed that there were times when the Fed needed to tolerate major shifts in interest rates in order to get inflation under control. Will future Fed officials also be willing to allow dramatic adjustments in interest rates, if necessary, to stabilize the economy? The Fed did not reduce interest rates quickly enough in 2007 and 2008. 

Let’s hope that they’ve learned a lesson from a man who knew how to take the difficult course. 

Scott Sumner is an emeritus professor of economics at Bentley University and the Ralph G. Hawtrey chair of monetary policy at the Mercatus Center at George Mason University.