When Volcker Beat Inflation

You have to be of a certain age to fully appreciate the singular accomplishment of former Federal Reserve Chairman Paul Volcker, who passed away on Dec. 8. Volcker is credited with finally bringing to heel an inflationary period that had dogged the U.S. economy for years and had bedeviled the administrations of three U.S. presidents.

But wait, inflation — what the heck is that?

There is an entire generation of people in the United States who have only experienced an era of low inflation. The inflation rate in November was a benign 2.05%. In fact, economists and central bankers have been more concerned about deflation in recent years. For the first five months of 2015, the U.S. inflation rate was actually slightly negative.

During periods of high inflation, prices and wages continue to rise in an interconnected spiral, with each one pushing the other higher. Today, the Federal Reserve’s monetary policy is to maintain price stability within a 2% inflationary band.

The story behind Volcker’s inflation fighting accomplishment begins in 1971, during Richard Nixon’s first term as president. As Nixon was preparing to run for reelection, the inflation rate had increased to around 4.6% and the unemployment rate was around 6%. To bring both rates down, Nixon introduced a system of wage and price controls that not only proved to be unsuccessful, but resulted in a phenomenon known as “stagflation,” an unholy alliance of stagnant economic growth, high unemployment and high inflation.

When Gerald Ford succeeded Nixon as president in August 1974, the inflation rate had climbed to 10.85%. Ford instituted a program called “Whip Inflation Now,” which was essentially a voluntary call to action urging U.S. consumers to control their spending. High inflation tends to drive over-consumption because the product you’re contemplating buying today will most likely cost more in the future. Ford even had WIN buttons made that he encouraged people to wear. The WIN program was essentially a public relations ploy that did nothing to control inflation.

The story then shifted to the administration of Jimmy Carter. Inflation had dropped to 5.22% when Carter took office in January 1977, but would spike to 9.28% in January 1979 due in part to severe disruptions in the global oil market and, later, the Iranian revolution. The inflation rate would reach 10.09% two months later and stay at double digits for the remainder of his presidency. Carter’s initial strategy to fight inflation was controlling government spending, but in July 1979 he appointed Volcker — then serving as president of the Federal Reserve Bank of New York — as chairman of the Federal Reserve.

Volcker was a known inflation hawk who lived up to his reputation. His strategy to defeat inflation was to control the supply of money rather than establish a specific interest rate target — to turn the money spigot off. Restricting the flow of money sent interest rates skyrocketing, with the prime rate peaking at a record 21.5% in December 1980.

Volcker stood an imposing, 6 feet, 7 inches tall. A New York Times obituary described him as a “towering, taciturn and somewhat rumpled figure.” He was often photographed with an unlit cigar in his hand. It was Volcker’s emotional and intellectual toughness that finally overcame inflation.

Soaring interest rates led to social unrest and unrelenting criticism early in his tenure as Fed chairman. Farmers, auto dealers and builders all complained that the high interest rates were killing their businesses.  “Farmers once surrounded the Fed’s Washington building with tractors. Home builders, forced to shut down, sent sawed-off two-by-fours with messages to the [Federal Reserve Board],” Volcker wrote in his 2018 memoir, “Keeping At It: The Quest for Sound Money and Good Government.”

Volcker’s strong monetary medicine eventually pushed the U.S. economy into a short, six-month recession in 1980, and then a much deeper recession in 1981-82. The historically high interest rates that resulted from Volcker’s tightening of the money supply probably cost Carter his reelection to a second term, although the Iranian hostage crisis played a role as well.

The inflationary fever finally began to break in 1982, and by June 1983 had dropped to 2.58%. The inflation rate would bounce up and down within a fairly narrow band for the next several years, but the worst was over.

Volcker had won.

There is an amusing anecdote in Volcker’s memoir that ties a nice bow on his accomplishment. “My Federal Reserve driver, Mr. Pena, provided the conclusive evidence of victory,” Volcker wrote. “On the way to speak at a big Washington dinner, I spotted a book on the front seat next to Mr. Pena with the title, ‘How to Live with Inflation.’ “Shocking that my own driver had no confidence in me! But, Mr. Pena explained, he’d only bought the book because its price had been marked down to $1.98 from $10.95. The crowd at the dinner appreciated the story.”