How Paul Volcker broke inflation by doing one unusual thing

Paul Volcker was sworn in as chairman of the Federal Reserve on August 6, 1979. The Consumer Price Index was running at 11.8 percent year over year. Over the next seven months it would reach 14.8 percent, a level not seen in the United States since the immediate aftermath of World War I.

Why the old playbook was not working

The accepted economic theory of the 1960s and early 1970s held that there was a stable tradeoff between unemployment and inflation. Lower unemployment meant higher inflation, and vice versa. If you wanted less inflation, you accepted some recession, and the relationship was predictable enough to manage.

By the late 1970s, that tradeoff had stopped working. Unemployment and inflation were both high, a combination called stagflation that the models of the previous decade did not really allow for. Businesses and workers had started pricing ongoing inflation into wage negotiations, contracts, and price lists. The expectation of continued inflation had become self-fulfilling.

The Volcker decision

Volcker made a technical decision in October 1979 that sounded minor. The Fed would change its operating target from interest rates to monetary aggregates, specifically the growth rate of bank reserves. The practical effect was that rates were no longer being managed for smoothness. They could spike, and they did.

The Federal Funds Rate, the overnight rate at which banks lent to each other, reached about 20 percent in June 1981. The prime rate, charged to commercial borrowers, touched 21.5 percent. Mortgage rates went above 18 percent. Unemployment rose above 10 percent. There were two recessions, in 1980 and more severely in 1981 to 1982.

What it took and what it gave

The political cost was enormous. Farmers drove tractors onto the Fed's plaza in protest. Members of Congress introduced bills to remove Volcker. Small business associations sent him bricks in the mail, representing unsold houses. The Reagan administration was nominally supportive but visibly unhappy. Volcker kept going.

By 1983, inflation was down to around 3 percent. It stayed there for most of the following 35 years. The 'Great Moderation' that followed, a long period of stable prices and steady growth, is largely attributed to the credibility Volcker built. When inflation returned as a significant issue in 2022, the Fed under Jerome Powell explicitly invoked the Volcker precedent. Breaking inflation expectations, once entrenched, requires a willingness to cause a recession, not a hope of avoiding one.