The Fed must emulate the tactics of Volcker’s fight against inflation

The writer is a former chair of the US Federal Deposit Insurance Corporation and a senior fellow at the Center for Financial Stability

US Federal Reserve chair Jay Powell has expressed deep admiration for Paul Volcker, his legendary predecessor who defeated the high inflation that plagued the US economy from 1965 to 1982.

Then, as now, Volcker was fighting more than a decade of loose monetary policy, combined with supply shocks stemming from geopolitical turmoil. But though he extols the man, Powell is deviating from Volcker’s methods. This is perhaps why inflation continues to accelerate, now topping 9 per cent in the US and spreading rapidly throughout the world.

While Volcker fought inflation by restraining growth in money supply, Powell’s favoured approach is aggressive interest rate hikes. He also seems ready to lower rates if we enter recession. The recent bond rally and the Fed’s own stress tests of banks support this view. But Volcker had to keep monetary policy tight through two recessions to finally beat inflation. If he is to tame inflation expectations, Powell must strongly signal that he is prepared to do the same. 

Each year, the Fed puts the nation’s largest banks through stress tests to determine whether they can withstand adverse economic environments. The most severe scenario tested by the Fed this year assumed a deep recession that would cause consumer prices to drop from 8.25 per cent to 1.25 per cent, and short-term interest rates to go to zero. 

But the Fed did not try out the scenario that most concerns many experts: the economy plunges into a deep recession, but consumer prices and interest rates remain high. This was exactly the real-life “stagflation” scenario confronted by Volcker when he became Fed chair in 1979 and something that we should all be thinking about now.

Volcker kept monetary policy tight through the recessions of 1980 and 1981-82, despite populist revolt, bipartisan demands for his firing, even a public call from the US Treasury secretary to ease money supply, which he famously dismissed as an “unusual communication”. During this time, unemployment rose to double digits, but he held firm until inflation finally fell, from more than 14.8 per cent in 1980 to less than 5 per cent by the end of 1982.

His predecessors had pursued “stop and go” policies, continually raising rates when unemployment was falling and lowering them again when jobless levels rose. This had hurt the Fed’s credibility, whipsawed markets, and further entrenched inflation in the economy. Volcker wisely and bravely refused to revert to that tactic.

Given this history, it would be folly for Powell and the Fed to embrace “stop and go” again today. They should also follow Volcker’s example by restraining money supply. Too much money chasing too few goods and services lies at the heart of this and every other inflationary moment.

Regrettably, while the Fed started raising rates in March, it waited until June 1 to start draining excess cash from the system. It announced it would shrink its $8.4tn domestic portfolio by up to $47.5bn each month, but it had only declined by about $28bn as of July 13.

Both Powell’s approach of raising rates and Volcker’s of restraining money supply lead to tighter monetary conditions. But the current approach involves the Fed, not the markets. The Fed sets rates and makes judgments about the size and pace of the increases. It then implements its policy by increasing the rate of interest it pays large financial institutions to keep their money with the central bank instead of lending it out. 

For banks, this means higher rates on their Fed reserve accounts. For other financial intermediaries such as money market funds, it means higher rates on certain short-term Treasury transactions called “reverse repos”. These institutions will be reluctant to lend unless their expected returns exceed the risk-free rate they are getting from the Fed. The Fed’s bill for this interest is high and growing. At the end of June, reverse repo balances were paying a rate of 1.55 per cent, while reserve balances paid 1.65 per cent. (if only we could all get those rates on our bank accounts). 

In contrast, to take money out of the system, the Fed simply sells some of its securities or lets them mature without reinvesting the proceeds. This leads to higher rates, as private investors become more dominant in markets from which the Fed is withdrawing. Importantly, the markets, not the government, drive the rate increases. This avoids the unseemly appearance and excessive cost of the Fed essentially paying institutions not to lend. 

For many years, the Fed has unwisely paid little attention to the huge volume of money its accommodative polices have created. It now needs to follow Volcker’s example and attack excess money supply head-on. It should replace the shock and awe of major interest rate hikes with new targets based on money supply, and aggressively shrink its portfolio, selling securities at a loss to do so, if necessary.

It should also conduct new stress tests to assure the public that banks can withstand severe stagflation. We are fortunate that Powell is a courageous leader — now he must mirror Volcker’s strategic skilfulness as well.