The ripple effect of the Volcker Shock for the economy

President Jimmy Carter nominated New York Federal Reserve Bank President Paul Volcker to chair the Federal Reserve Bank in July 1979 to deal with the immediate issue of hyper-inflation. He was confirmed by the Senate in August and served as chair until 1987.

The no-nonsense, independent-minded Volcker oversaw a program of financial austerity that left a deep imprint on the U.S. economy and financial system. Unlike elected officials, he understood that there are times when you must incur short-term costs to achieve long-term benefits. Volcker is widely regarded as one of the best Fed chairpersons in history.

When he took the reins of the central bank, the U.S. was mired in a decade-long period of rapidly rising prices and weak economic growth that had come to be known in the1970s as “stagflation.” The month Volcker took office, unemployment was 6 percent and inflation was barreling towards 15 percent.

One advantage he enjoyed was that the nation was far less in debt than in the current environment. Unlike today, Volcker did not have to be concerned that raising interest rates to fight inflation would risk triggering a debt crisis. Conversely, if the current Fed maintains a loose monetary policy, it risks double-digit inflation.

In a moment market watchers will never forget, Volcker opted to cleave to his monetarist teaching by attempting to control interest rates by contracting the money supply rather than the fed funds rate. The Fed had historically targeted an interest rate in the short-term money market to loosen or tighten the money supply.

Then as now, the Fed set a target for short-term interest rates, then bought and sold securities to ensure that rates actually settled at that level. Volcker concluded that the Fed needed to change strategies and start targeting the actual amount of money floating in the economy. As he said, “it was time to act—to send a convincing message to markets and to the public.”

So just two months after taking office in August 1979, Volcker attacked inflation by using the Fed’s powers to directly target the growth in the quantity of money. He would leave interest rates alone to set themselves freely in the market.

It was shock therapy. By April 1980, interest rates had spiked above 17 percent and in the second quarter of 1980, the gross domestic product contracted by 7.9 percent. The extreme rise in interest rates was called the Volcker Shock.

The action indeed triggered what was then the deepest economic downturn since the Great Depression and drove thousands of businesses and farms to bankruptcy. Unemployment peaked at 10.8 percent.

But by the mid-1980s Volcker’s medicine was working. The reduced money supply and high cost of credit finally vanquished inflation and inflationary expectations.

Volcker’s steadfast commitment to his shock therapy and willingness to take unpopular policy actions made him the target of opprobrium by politicians of all ideological stripes. He believed central bankers needed to steer the economy free of political considerations. Protesting his policies, home builders sent the Fed unused two-by-fours, auto dealers mailed keys to the cars for which there were no buyers, and farmers drove their tractors around the white marble Fed building.

But the double-digit interest rates and sharp double-dip recession that followed the tightening of credit finally slayed the inflation dragon. It plunged below 4 percent in 1983, and by 1986 it was down to around 2 percent.

Interest rates eventually followed. Once the out-of-control inflation ended, he cut rates. This restored faith in the dollar, the Coca Cola of money, and laid the groundwork for a quarter century of low inflation, steady growth, and rare and mild recessions.

It can be said of Volcker as Hamlet said of his father: “He was a man, take him for all in all. I shall not look upon his like again.”

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