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Jerome Powell’s Volcker deficit

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Poor Jerome Powell. With US inflation close to a 40-year high, the Federal Reserve chair knows what he needs to do. He has professed great admiration for Paul Volcker, his 1980s-era predecessor, as a role model. But, to paraphrase US Senator Lloyd Bentsen’s famous 1988 quip about his vice-presidential rival, Senator Dan Quayle, I knew Paul Volcker very well, and Powell is no Paul Volcker.


Volcker was the quintessential US public servant. He smoked cheap cigars, wore rumpled off-the-rack suits, and had a strong distaste for the glitz of Washington power circles. His legacy was a single-minded discipline in attacking a pernicious Great Inflation.


Unlike the modern Fed, which under Ben Bernanke’s intellectual stewardship created a new arsenal of tools – balance-sheet adjustments, special lending facilities, and the “forward guidance” of outcome-dependent policy signals – the Volcker approach was simple, blunt, and direct.


Monetary policy, in Volcker’s view, started and ended with interest rates. He once said to me, “If you are not prepared to act on interest rates, you may as well get out of town.”


Volcker, of course, raised US interest rates to unheard-of levels in 1980-81, and there were many who did want him to get out of town. But howls of protest from builders, farmers, citizens’ groups, and members of Congress demanding his impeachment did not dissuade him from an unprecedented tightening in monetary policy.


It was long overdue. Under Volcker’s predecessor, Arthur Burns, the Fed had become convinced that inflation was part of the US economy’s institutional fabric.


The price level was thought to have less to do with monetary policy than with the power of labour unions, cost-of-living wage indexation, and regulatory pressures on costs stemming from environmental protection, occupational safety, and pension benefits. Burns argued that oil and food-price shocks reinforced the institutional biases of an inflation-prone US economy.


In other words, blame the system, not the Fed. The Fed’s research staff, which at the time included me, squirmed but raised no objections.


Volcker did more than squirm when he took over as Fed chair in August 1979. At the time, the consumer price index was surging by 11.8% year on year, on its way to 14.6% in March 1980.


Volcker was determined to find the interest-rate threshold that would break the back of US inflation. Using the political cover provided by the 1978 Humphrey-Hawkins Act, which formalised the Fed’s price-stability mandate, and drawing operational support from a shift to targeting the money supply, Volcker went into action.


The Fed increased its benchmark federal funds rate 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 a monetary-policy tightening that eventually pushed the funds rate to a monthly peak of 19.1% in June 1981. Only then did the fever of double-digit inflation break.


By late 1982, with the US in deep recession, annual headline CPI inflation had slipped below 4%, and the Fed started to reduce the benchmark policy rate. Mindful of the deeply entrenched inflationary psychology still gripping America, the Fed moved slowly and cautiously. Volcker, having broken the back of inflation, was not about to “leave town” until the Fed’s mission was complete.


Fast-forward 40 years, and Powell’s problem is glaringly apparent. Yes, the world today is certainly different than it was back then.


But the modern Fed apparently has no institutional memory of the mistakes that it made in the Burns era. In 2021, there was a striking sense of déjà vu when US central bankers treated the initial surge in inflation as transitory and squandered the credibility of well-anchored expectations of low inflation.


© Project Syndicate, 2022


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