Paul Volcker Slays the Inflationary Dragon

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Paul Volcker Biography


Paul Volcker was born in Cape May, New Jersey in 1927. He received his undergraduate studies at Princeton University and later attended Harvard University and the London School of Economics for his graduate studies. His career started in 1952 with the Federal Reserve Bank of New York. He left after five years where he became a financial economist at Chase Manhattan Bank. He spent five years with Chase Manhattan Bank and later returned to become the vice-president and director of planning. During his hiatus from Chase Manhattan Bank he worked as the director of financial analysis for the U.S. Tresury Department. He also worked with the head of the Treasury for four years until 1979, when he became the chairman of the Fed. He remained Chairman of the Federal Reserve Bank until 1987.

Pre 1979 Economic Conditions


Before Volcker became head of the Fed in 1979 the economy was experiencing a period of decline. Between high inflation and oil shocks the Federal Reserve needed to take an active role in slowing expected inflation. Because inflation did not seem to be targeted by the Fed pre-Volcker the country experienced systematic increases in inflation from year to year. Another key element that Volcker attacked and was looked over before he was appointed was inflationary expectations. This systematic increase of inflation had built into the country an expected inflation raise from year to year which halts economy growth. The inflation was highly volatile and the country was experiencing recessions partly due to the Fed's highly accomodative attitude which let short-term interest decline while anticipated inflation rose. To try and combat these situations the Fed tried to raise nominal rates but this attempt failed because the amount that the nominal rates were raised was less than the increase in expected inflation. The oil crisis of 1973-74 generated monetary accomodation in the short run which helped keep the economy from experiencing a period of output-growth reduction. The response to this exogenous shock could not hold up in the medium or long run which resulted in a slowing of output-growth. Oil shocks and inflation were not the only problems within the decade. While supply shocks raised the price level it could not explain persistent periods of inflation. In addition, the increase in inflation was experienced by the United States before the oil crisis emerged in 1973. Research shows that the oil crisis did push up the price of oil but the monetary policy that was enacted in response of the TWO oil shocks of the decade were much of the subsequent downturn in output. While Johnson, president during the late 1960's before President Nixon, had instituted policy where unemployment fell by two percent, the more important figure of this policy was inflation only rose by three percent. This is expected when you look at a Phillips Curve where unemployment and inflation are inversely related.


The problem during the 1970's was the country experienced stagflation where both unemployment and inflation rose at the same time. This would not be illustrated by a movement along the Phillips Curve but by a shift in the Phillips Curve out and to the right depicted in the graph above by the movement from the blue to the red line.

The Disinflation Effort

"The average American was likely to see his standard of living dramatically reduced in the 1980s unless productivity growth was accelerated"--- warning issued by the Joint Economic Committee of Congress

Aside from the Great Depression, the change in inflation that occurred during the early part of the 1980s represents the most important macroeconomic event of the 20th century. At the time however, the decision to change the FED's operating procedures was far from unanimous. During the September 1979 meeting, there was a 4-3 split decision regarding the most recent discount rate increase. Market participants viewed this increase as a weak response to inflation and expressed little confidence that the FED could tighten policy sufficiently enough to have any substantial influence. If the policies of the FED were expected to have a serious impact, there needed to be a shift in monetary policy.

In 1979 at the onset of his term at the FED, Volcker faced an annual average inflation rate of 9%. The inflation rate peaked in early 1980 at 11%. During Volcker's tenure, the economy of the United States experienced the largest business cycle declines since WWII, as the unemployment rate rose considerably and output fell.

In October of 1979, the FED relied upon the Monetarist school of thought to develop effective disinflation policies. By focusing on money growth the FED could allow interest rates to rise very high, until the supply and demand for money was brought back into balance. Volcker successfully argued for the new operating procedure and felt that the new monetary targeting could be compatible with an interest rate policy. Volcker reflects this opinion in the October 6th, 1979 FOMC transcript, stating

"This is not black and white. We could decide-to use an extreme example-that we don't want to say anything about a federal funds range in the directive today, but keep to ourselves the idea that the Desk should have plenty of leeway. If the market dictates- in the way it responds to what we're doing- that the federal funds rate should go temporarily to 15 percent, we'd let it go. I wouldn't worry about that. If sometime after 90 days- or it may take even longer- we find that this [new operating technique] has served its purpose, we can go back to including a federal funds range that is broad but nevertheless there, if we wish to."(FOMC transcript, 10-6-79, p. 17)

Recognizing that long-term interest rates were the key indicator of inflationary expectations, Volcker was able to successfully combat the high inflation. Even more crucial would be Volcker's unwavering confidence to stick with such a drastic policy change during a time of deteriorating economic conditions.

With the FED abandoning its federal funds target range the discount rate hit a high of 13.49%. Inflation first began to fall in 1981. By the end of 1983, the inflation rate had decreased to less than 5% and during 1984 and 1985 it declined to 3%.

Interest Rates


The Recession of 1981-82


The recession that spanned from 1981 to 1982 was the worst economic years spanning back to the Great Depression. What had led the nation back into recession was a direct result of restrictive monetary policy Volcker had enacted in 1979 when he took over as Chairman of the Federal Reserve. Many people say he meant to cause a recession but what his main goal was to weed out inflationary expectations throughout the country. Volcker tightened money supply which, in turn, stopped job growth. At this time the country was operating well below capacity and unemployment approached record levels for postwar years. Companies were lowering prices and cutting wages during this period just as workers were lower their wage demands just to stay employed.

In December of 1980 the institution of negotiable order of withdrawal was implemented known as NOW accounts as well. This meant banks were allowed to pay a regulated fixed interest on checking accounts. Besides a couple of states in the Northeast, NOW accounts had not been used since 1935. The hopes of the now accounts was for people to shift money from demand deposit accounts into interest bearing checking accounts whwhich would raise the money supply which, in these years, were slightly altered to accomodate these new NOW accounts. To stay on top of these accounts the Federal Reserve tried to estimate the magnitude of the changes in the money supply. The estimations were not very accurate making it difficult to have effective monetary policy.

The severity of the recession was also a result of the small period of economic upswing faced in 1980 after the second oil crisis. Once Volcker realized the money supply was not tight enough the Federal Reserve tightened the money supply even further. This caused unemployment to reach up to 13.5 percent in its worst year. Record interest rates that exceeded the record breaking rates of previous years coupled with a growth rate which was barely larger than that of the growth rate of 1979 kept the country in the recession.


When the United States recovered out of recession post 1982 it came out quite slowly. Interest rates were more moderate and inflation was declinging. The Federal Reserve still were enforcing tight monetery policy and were restrictive on money growth which did slow inflation throughout the recovery years but, it also slowed an economic boom which was possible during the same time frame.

The introduction of the Market Mutual Funds and also the new super NOW accounts helped the country climb out of the recession by deregulating some of the policy and also by having the super NOW accounts fluctuate with the market instead of having a fixed rate. This was all done by the Depository Institutions Deregulations and the Monetary Control Act.

Inflation Slayed

With the inflationary dragon finally slayed, in 1982 the Fed returned to a policy of smoothing out interest rates. It did this by placing less emphasis on monetary aggregate targets and shifting to borrowed reserve targets as a monetary tool. A borrowed reserve target smoothes interest rate because as output rises, interest rates will also rise. This causes bank to borrow more money from the Fed and therefore the amount of borrowed reserves will increase. In an effort to prevent the level of borrowed reserves from exceeding its target, the Fed will lower interest rates through open market purchases to increase the price of bonds. The result of using a borrowed reserve target is that the Fed is able to prevent a rise in interest rates. Although, by using this tool, the open market purchases by the Fed will increase the monetary base, which will then lead to an increase in the money supply. As shown here:

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The most important impact of Volcker's actions was not saving the country from high levels of inflation or wringing out the inflationary expectations that workers had. Volcker was the first chairman of the Fed to thoroughly implement Milton Friedman's theories. Volcker shifted the Fed's primary priority from controlling unemployment to price stability and controlling inflation. The adverse short run effects of what Volcker did was unemployment went way up. However, in the long run, as the economy was expanding, unemployment gradually fell. As the economy continued to expand, inflation stayed under 3% almost every year for the next 25 years. Greenspan and Bernanke continued this process by reducing inflation even more, and by removing inflationary expectations from the economy.

Criticisms of Volcker


Saving the country from very high inflation and removing the expectations does not come without consequences. Although the American people were happy that inflation was beings exterminated, the US economy was sent into a recession to accomplish this. Interest rates were as high as 20% and the unemployment rate was just below 10%. Many people demanded to know "how could Volcker conduct a policy that appeared to throw people out of work?" The industries that were hit hardest at this time were the home-building industries and the automobile industries, because with interest rates at unprecedented levels, people were hesitant to purchase new homes and cars. Volcker even received death threats written on bricks and 2 by 4's from unemployed carpenters and out of work car salesmen. Volcker also recieved a number of harsh criticisms from the fiscal authorities such as Whitehouse spokesman Larry Speakes and President Reagan for putting too much emphasis on fighting inflation.


Reverting Back to Interest Rate Targets

In October 1982, Volcker announced that it would no longer focus as intensely on M1. Satisfied with its inflation fighting campaign, the FED shifted its attention to borrowed reserves as an operating target. The change in policy led to interest rates behaving with much less variation. In February 1987, the FED deserted the policy of setting M1 targets all together. This change was supported by the opinion that money had become increasing difficult to define and also by the realization that M1 and economic activity may not be as closely related as previously thought to be. There was a brief period during which M2 was used in the FED’s policy determination; however, this relationship also broke down. Finally in the early 1990s, Chairman Alan Greenspan testified before Congress that the FED would no longer endorse monetary targets. The early 1990s saw the FED return to an interest rate targeting policy and from late 1992 to February 1994, the FED kept the federal funds target set at 3%. Although the federal funds rate is no longer set at 3%, the monetary policy is still highly dependent upon the FED’s ability to react to economic changes by setting the proper federal funds rate.


Mishkin, Frederick. The Economics of Money, Banking, and Financial Markets, 8th Edition. Boston. Pearson Education 2007.

Goodfriend, Marvin and King, RobertG., "The Incredible Volcker Disinflation" (August 2005)

Taylor, John B., "Journal of Economic Literature", Vol. 33, No. 2. (June,1995), pp. 777-784

Hakes, David R., "Journal of Money, Credit and Banking", Vol. 22, No. 3 (August, 1990), pp. 327-337

Hadjimichalakis, Michael G., The Federal Reserve, Money, and Interest Rates. New York. Praeger 1984.