This kind of shock to the economy will have consequences

The rich but largely forgotten history of people protesting high interest rates at the Federal Reserve seems insane today, when Americans are so used to such easy access to borrowed money.

We’re talking about the late 1970s and early 1980s, when high inflation became so ingrained in the American psyche that killing it shocked the system, leading to daily interest rates on par with those charged. today from credit cards.

The medicine to cure inflation has ushered in a double recession – in which a recession was followed by a brief recovery and then another recession – and put millions of Americans out of work.

The architect of that shock, former Federal Reserve Chairman Paul Volcker, is now hailed for making it politically difficult and creating the environment for decades of subsequent economic growth.

But it resisted criticism as inflation subsided.

The president who entrusted Volcker with leadership of the Fed, Jimmy Carter, lost his job amid a crisis of confidence and voter malaise. Ronald Reagan allegedly rebranded Volcker for a second four-year term before the two quarreled.

The Volcker shock. People this week are remembering the “Volcker shock,” which altered the course of the US economy at the time, as today’s Federal Reserve imposes its second consecutive massive rate hike.

Read these CNN Business articles for the full history of Wednesday’s excursion:

Now, back to Volcker.

What kind of rates were they looking at while taking Volcker on inflation?

Mortgage rates have skyrocketed. Let’s take a look at the 30-year fixed mortgage rates, which follow close to the Fed-controlled rates.
The 30-year average fixed rate was already excessive and approaching 12% in October 1979, even before Volcker’s dramatic announcement of drastic anti-inflation measures. The average rate within months it had risen to over 16%. The average rate on a 30-year fixed mortgage was above 18%, its staggering high, in October 1981.
Today we are still a long way from those highs of the 1980s; Fixed 30-year rates nearly doubled in one year to nearly 6%.

Volcker’s legacy is impressive. Every story you read about Volcker will mention that he was 6 feet 7 inches tall. But he has an outsized legacy to match.

In addition to providing the harsh medicine that ended the runaway inflation of the 1970s, it was credited with the “Volcker rule”, which for a time prevented banks from trading their assets.

Chris Isidore wrote the CNN obituary for Volcker in 2019. I asked him how Volcker might see today’s fight against inflation.

He made these important points:

Volcker was willing to make tough choices. Volcker believed that the Fed should do whatever it takes to bring prices back into line. Under his leadership, the central bank raised the key rate to 19% in January 1981.

There have been consequences. Its high interest rate policy caused not just one, but two recessions in a short time: one from January 1980 that lasted until July 1980, followed shortly after by the recession that began in July ’81 and continued until November 1982.

In November 1982, the unemployment rate reached 10.8%, nearly a percentage point higher than it hit in the wake of the Great Recession 12 years ago.

It was far worse inflation than we have today. Volcker had to fight much more severe inflationary pressures, with the rate of rise in the consumer price index reaching a high of 14.8% in March 1980, well above the current rate of 8.3%. .

Volcker faced a wage-price spiral. Many more workers had union contracts than today, and many of those contracts had cost-of-living adjustment clauses, or COLAs, built in that automatically raised wages when prices rose. This is not the case today.

Today the Fed has less control. Many of the factors in today’s high inflation are beyond the Fed’s control, including spikes in oil and food prices caused by the war in Ukraine and supply chain problems caused by the Covid-19 pandemic, which continue to increasing the production costs of many products and causing shortages in the face of high demand.

Inflation can become a self-fulfilling prophecy

Much of the Fed’s job in taming inflation is to convince people that inflation has been tamed, according to former Fed official David Wilcox, who is now a researcher at the Peterson Institute for International Economics.

Shortly before this latest rate hike, he wrote an opinion piece for CNN Business, in which he offered two avenues to the United States:

The optimistic view is that people believe inflation is under control. “If households and businesses believe inflation will return to 2% in the not too distant future, the Fed’s task in achieving this will be much easier,” Wilcox wrote.

The pessimistic view is that people think it is here to stay. “The experience of rising prices at the gas pump and grocery store over the past year may have conditioned families and businesses to expect more or less the same,” Wilcox wrote. “In that case, the Fed will have to raise its official interest rate much higher – and the future economic crisis will be much deeper.”

Wilcox said Volcker was trying to get Americans out of a general acceptance of too high inflation. Today, Wilcox looks optimistic and expects inflation to be lower within a year and around the 2% target within two to three years, although he who knows what will happen with the pandemic and the war in Ukraine.

Wilcox refers to Volcker as “the patron saint of inflation control” and notes that current Fed Chairman Jerome Powell often invokes Volcker’s name.

It is usually in enthusiastic terms. This spring, Powell praised Volcker for fighting on two fronts, “killing, as he called it, the ‘inflationary dragon’ and dismantling the public’s belief that high inflation was an unfortunate but immutable reality.”

Hopefully it isn’t, and these interest rate hikes don’t have the same unwanted consequences Volcker did over 40 years ago.

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