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Marc-Antoine Collard (Rothschild & Co): The Volcker shock

03.04.2023 - Before 1965, US inflation was stable for years, hovering around or below 2%. But President Lyndon Johnson then began implementing big increases in spending, as part of both the war on poverty and the escalating war in Vietnam. While some of that spending was funded by new taxes, much of it wasn’t, leading to higher deficits. Yet, at a time when the economy was near full employment, this policy translated into higher inflation increased by the first oil shock in history.

In August 1979, Paul Volcker was appointed Chairman of the Fed, which from December 1979 to February 1980 took actions that led to a substantial rise in interest rates. However, these aggressive interest rate policy actions would only serve to contain inflation temporarily. Indeed, when the economy fell into a sharp recession in January 1980, the Volcker Fed behaved in a manner consistent with prior experiences, undertaking restrictive monetary policy in the face of rising inflation, but promptly reversing field to fight the recession as unemployment mounted.

By July 1980, the recession was officially over in part due to looser monetary policy, but after all the turbulence, inflation had barely been contained. In December 1980, inflation reached more than 12% when the fed funds rate reached 19%. The FOMC then realised that its restrictive policy could lead to a new recession, but Volcker argued that holding the line on inflation was warranted and was adamant that the Fed not back down.

The economy officially entered a recession in the third quarter of 1981. Unemployment grew from 7.4% at the start of the recession to nearly 10% a year later. Volcker continued to maintain a firm tone. By the end of 1982, inflation had fallen to 4% and long-run interest rates began to decline. The Fed allowed the federal funds rate to fall back to 9%, and unemployment declined. Overall, the 1981-82 recession was the worst economic downturn in the US since the Great Depression.

Today, soaring commodity prices in the wake of Russia's invasion of Ukraine have exacerbated already high inflationary pressures. In this regard, the current situation resembles the oil shocks of the 1970s. Moreover, then as now, monetary and fiscal policies were accommodative before these shocks occurred. However, the 1970s were marked by considerable structural economic rigidities, and the energy intensity of GDP has declined considerably since the 1970s. In addition, there has been a paradigm shift in monetary policy since then.

Thus, a key lesson from the 1970s is that central banks need to act in a pre-emptive manner to avoid a loss of confidence in their commitment to maintaining low inflation, specified today in their inflation targets. It is also critical to avoid inflation de-anchoring. Incidentally, it remains to be seen if today’s almost unprecedented global monetary tightening will also morph into financial instability as it was the case in the early 1980’s.

Lesen Sie mehr im ausführlichen Dokument "The Volcker shock" (in englischer Sprache) mit Grafiken.