Opinion: I knew Paul Volcker (who killed the Great Inflation), and Jerome Powell is not Paul Volcker

Volcker was the exemplary American public servant. He smoked cheap cigars, wore crinkled suits off the racks, and had a severe aversion to the glamor of Washington’s power circles. His legacy was a single-minded system in attacking the insidious Great Inflation.

Now read this: Most Fed officials tend to raise rates by 1/2 point in the “next few meetings”

‘Out of town’

In contrast to the modern Fed, which, under the intellectual stewardship of Ben Bernanke, has created a new arsenal of tools—balance sheet adjustments, private lending facilities, and “forward guidance” of results-based policy signals—Volcker’s approach has been simple, straightforward. Monetary policy, in Volcker’s view, started and ended with interest rates. He once told me, “If you’re not ready to act on interest rates, you might as well get out of town.”

Naturally, Volcker raised interest rates to unheard of levels in 1980-1981, and there were many who wanted to get out of town. But the outcries from builders, farmers, citizen groups and members of Congress to demand his impeachment did not deter him from an unprecedented tightening of monetary policy.

It’s too late. Under Volcker’s predecessor, Arthur Burns, the Federal Reserve became convinced that inflation was part of the institutional fabric of the economy. The price level was thought to have less to do with monetary policy as with the strength of labor unions, wage calibration for the cost of living, and regulatory pressures on costs arising from environmental protection, occupational safety, and pension benefits. Burns argued that the oil and food price shocks reinforced the institutional biases of an inflation-prone economy.

Don’t blame us!

In other words, blame the system, not the Federal Reserve. The Fed research staff, who included me at the time, were confused but did not raise any objection.

Volcker did more than grumble when he took office as Federal Reserve Chairman in August 1979. At the time, the CPI was up 11.8% year over year, on its way to 14.6% in March 1980. Volcker was determined to find interest. – Rate threshold that will break back inflation. Using the political cover provided by the Humphrey Hawkins Act of 1978, which formalized the Federal Reserve’s mandate on price stability, and withdrawing operational support from switching to targeting the money supply, Volcker got to work.

The Fed raised its benchmark fed funds rate FF00,

from 10.5% in July 1979 to 17.6% in April 1980. Volcker then reversed course during an ill-advised but short-lived experiment with credit controls in the spring of 1980, before resuming monetary policy tightening that eventually pushed the interest rate to a monthly peak of 19.1% in June 1981. Only then did the double-digit inflation fever subside.

By late 1982, with the United States entering a deep recession, the annual headline CPI inflation rate had fallen below 4%, and the Federal Reserve began lowering the standard policy rate. Aware of the deeply entrenched inflationary psychology that still dominates America, the Fed moved slowly and cautiously. Volcker, having broken the back of inflation, was not about to “leave town” until the Fed’s job was complete.

There is no institutional memory

40 years later, Powell’s problem is starkly clear. Yes, today’s world is definitely different than it was back then. But the modern Fed clearly has no institutional memory of the mistakes it made in the Burns era.

In 2021, there was an astonishing sense of going backwards when US central bankers treated the initial spike in inflation as fleeting and discredited well-established expectations of low inflation.

The Fed viewed the COVID-19 shock the same way it did the global financial crisis of 2008-2009, injecting massive monetary stimulus to address what it was convinced would be a long-running deficit in aggregate demand. In the past, this was a huge policy mistake.

As pandemic-related lockdowns quickly gave way to reopening the economy, aggregate demand, buoyed by massive fiscal stimulus, came back strong. And in the face of now chronic disruptions in the supply chain, this post-lockdown take-off has amplified our generation.

Unparalleled cash housing

Powell’s problem is most evident when viewed through the inflation-adjusted lens of real interest rates. Over the 51 months of his leadership of the Fed (through April 2022), the average real Fed rate has averaged -1.95% (pressure on the minus sign). This extraordinary cash residence is unparalleled in modern times. The real money rate averaged -0.05% for eight years under Burns, -0.7% during Bernanke’s eight-year tenure, and -0.9% for four years under his successor Janet Yellen.

Under Volcker, by comparison, the real federal funds rate has averaged 4.4% for eight years (emphasis on the positive sign). Moreover, despite the determination of the new Fed Powell to move quickly to confront what he sees as a serious inflation problem, I believe that the Fed funds rate will remain below the inflation rate through 2023. This would push the Powell average to -2.25% over the 59 months ending December 2022.

No, I’m not arguing that Powell needs to repeat Volcker’s crackdown. But if the Fed wants to avoid a repeat of the stagflation of the late 1970s and early 1980s, it needs to recognize the unusual gap between the 4.4% real interest rate for Volcker and -2.25% for Powell.

It is a delusion to think that such a highly adaptive political path could solve America’s worst inflation problem in a generation.

Like Volcker, Powell takes his public service job very seriously. Unfortunately, as Bentsen said, this is where the comparison ends.

Stephen S. Roach, former president of Morgan Stanley Asia, Yale University faculty and author coming”Accidental Conflict: America, China and the Clash of False Narratives (Yale University Press, November 2022).

This comment was published with permission from Project Syndicate – Jerome Powell’s Volcker

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