It Took Longer Than Generally Remembered for the Volcker and Greenspan Fed To Restore Price Stability
March 17, 2022
Several questions at Fed Chairman Powell’s press conference yesterday tried to elicit a response about whether it is possible to shrink U.S. inflation back to the target of 2.0% without nearly stalling economic growth or even putting the U.S. economy through a recession. Powell did not say definitively yes or no but gave reasons for being hopeful such as the economy’s strong current momentum and historically low labor participation rate. He asserted that the top priority now is to restore price stability by late 2023. Officials have the necessary tools to accomplish that objective, and markets should not doubt their determination to get the job done as former Fed Chairman Paul Volcker did in the 1980’s.
A presumably big advantage this time is that barely a year has elapsed since inflation started to heat up. Core U.S. CPI inflation went from 1.2% at the end of 1965 to 6.6% by end-1970, backed down to 2.8% in mid-1972, insurged again to 11.1% by end-1972, fell back to 6.1% at end-1976, and climbed back to 10.9% by mid-1979 just two months before Volcker replaced G. William Miller as Fed chairman. By that time, officials realized that it would not be possible to sustainably or significantly cut inflation so long as the dollar was taking on a lot of water. A broad plan to rescue the U.S. currency was announced in November 1978, including a full percentage point increase of the Fed’s discount rate and assembling a war chest of resources to finance heavier direct currency market intervention. But that effort dealt with only part of a very complex system of inflationary factors that included self-fulfilling expectations of high inflation even in the long term.
In October 1979, the Federal Reserve announced a profound change in its approach to monetary policy by shifting its intermediate goal from targeting an interest rate to targeting banking reserves and thus monetary growth. Officials would make mid-course policy corrections weekly in response to how the data evolved. Inflation did not respond at first. Core CPI inflation rose to 11.3% at end-1979 and 12.2% by the middle of 1980 and also at the end of that year. The dollar again sagged in the second half of 1979. President Carter’s credit controls were one source of delay in the war on inflation, and the presidential election in November was another. Doing matched sales on the very first day after the election, the Federal Reserve got very serious about its task, a process that officials understood would make recession unavoidable.
The recession began in July 1981, and it would be deep as well as prolonged in lasting until November 1982. As inflation heated up in the mid-1960s, the federal funds rate had been reasonably aligned with the business cycle, rising from 3.5% in mid-1967 to 7.5% two years later, then falling back to 4.4% in late 1971, briefly hitting double digits in mid-1974 but settling back to 4.2% at end-1976. In the new policy scheme under Volcker’s leadership, officials let market forces determine interest rates while they remained single mindedly focused on slowing monetary growth. The federal funds rate was at 18.6% in mid-1981 just prior to the recession’s onset and when core CPI inflation had slipped back to 9.5%, but officials would allow the recession to run a whole year before making its first discount rate cut in July 1982.
By late-1982, core CPI inflation had dropped to 4.5%, but the federal funds rate of 9.5% was considerably higher. The recession had ended, but the fight against inflation would go on for many years longer. Core CPI inflation hovered around 4.5% — give or take — until the end of 1991, and the federal funds rate stayed above 7.0% except at times in 1987 when such carried a six-handle. Alan Greenspan replaced Volcker in August 1987, and the quest for price stability — defined now as 2% — still had some ways to go. Another recession in the early 1990’s — milder than the one a decade earlier — produced a stochastic drop in core CPI to 2.6% at end-1994, followed by a 3.0% settling point in 1995. During the second term of Bill Clinton’s presidency, the United States experienced very strong economic growth but also a good burst in labor productivity that managed to hold core CPI in a narrow range centered on 2.4% until end-1998 and finally to reach the promised land of 2.0% in 1999.
The federal funds rate, meanwhile, dropped from 9.5% in mid-1989 to 6.0% at end-1990 and 3.0% at end-1992 by which time officials for some time had been targeting interest rates again. The 3.0% level was maintained until early 1994, and an ensuing tightening cycle to 5.5% a year later was needed to throttle demand in the economy back to a level that enabled inflation to settle into the mid-2% corridor.
The Volcker Fed fight against inflation is generally remembered for what happened between U.S. inflation cresting above 14% in early 1980 and falling to around 4-5% by end-1982 and where it stayed for close to another decade. Core CPI inflation of 2.0% was not achieved until late 2002. The Powell Fed’s fight against inflation is beginning with total CPI inflation at 7.87% and core CPI at a 40-year high of 6.4%. The Fed uses the U.S. personal consumption expenditure deflator to target inflation, and such is at 5.2%, a 465-month high on a core basis excluding food and energy. Total PCE inflation is at a 40-year high of 6.1%. These are not as high as Volcker inherited, and Powell has the advantage that indicators of long-term inflation expectations aren’t out of control, yet. But the current Fed is afraid of moving in steps greater than 25 basis points, and the rate levels are starting from a much lower level than was the case with Volcker’s Fed.
A monetary tightening of the federal funds rate from 3% to 6% between February 1994 and one year later came perilously close to stalling out U.S. growth in the first half of 1995 and demonstrating yet again how hard it is to slow growth in aggregate demand to preserve price stability without also aborting the economy’s expansionary business cycle.
What all this might mean for the dollar is also suggested by the Volcker period. Between the end of 1980 and February 1985, the dollar nearly doubled in value against Deutsche mark from DEM 1.80 to 3.48 per USD. The Powell Fed believes that his assigned mission will be much more easily accomplished than what the Volcker Fed had to do. If current officials are still misjudging how well entrenched inflation has become, inflation might fail to fall the way they expect. That would hurt the Fed’s credibility, which market interest rates suggest is still quite solid, and that’s a recipe for dollar weakness.
The Powell Fed is also acting in a more complicated world than Volcker encountered. Possible new flareups in the Covid pandemic, Europe’s first big war in 75 years, China’s challenge to U.S. hegemony, and the unraveling of democracy in the United States by a rogue Republican Party are producing just some of the cross-currents that along with high inflation will determine the dollar’s fate.
Copyright 2022, Larry Greenberg. All rights reserved. No secondary distribution without express permission.
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