The “Volcker Moment”

Paul Volcker was nominated Fed Chairman on August 7 1979. Volcker was the ultimate insider, having made his career at the Fed where he became president of the New York Fed in August 1975, a position that assured him a permanent voting position at the FOMC, and the opposite of his predecessor William G Miller, a business executive with absolutely no monetary policy experience, who had replaced Arthur Burns in March 1978.

In his first Federal Open Market Committee (FOMC) meeting as chairman of the Federal Reserve Volcker “defined his moment” saying:

Economic policy has a kind of crisis of credibility. As a result, dramatic action to combat inflation would not receive public support without more of a crisis atmosphere”.

Under his bidding the outline of a plan that would revolutionize the Federal Reserve´s operating procedure was drafted. On sentence captures the essence of the plan: The FOMC “would seek to hold increases in the monetary base and other reserve aggregates to amounts just sufficient to meet monetary targets and to help restrain growth in bank credit, recognizing that such a procedure could result in wider fluctuations in the shortest term money market rates”.

And that went down on October 6 1979. For those who want a detailed account of the “revolution”, the March/April 2005 (Part 2) – Reflections on Monetary Policy 25 years after October 1979 – issue of the Saint Louis Fed Review is the place to go. In their presentation, David E. Lindsey, Athanasios Orphanides, and Robert H. Rasche discuss:

The Reform of October 1979: How It Happened and Why

And summarize it thus:

The record suggests that the reform was adopted when the FOMC became convinced that its earlier gradualist strategy using finely tuned interest rate moves had proved inadequate for fighting inflation and reversing inflation expectations.

The new plan had to break dramatically with established practice, allow for the possibility of substantial increases in short-term interest rates yet be politically acceptable, and convince financial market participants that it would be effective. The new operating procedures were also adopted for the pragmatic reason that they would likely succeed.

For our purposes we define the seven year period going from the fourth quarter of 1979 to the fourth quarter of 1986 as the “Volcker Transition”. That´s when the US economy transited from being a high inflation and high volatility economy to one characterized by low real volatility and low and stable inflation, a.k.a. the “Great Moderation” that extends from 1987 to 2007.

We provide a visual analysis of the period from the perspective of NGDP growth – our measure of the ease/tightness of monetary policy – inflation, measured as the year on year percent change in the personal consumption expenditures index excluding food and energy and the unemployment rate.

We divide the “transition” in two phases. The first goes from 1979.IV to 1981.III. When the Fed tightened in early 1980, inflation stopped rising but unemployment jumped. Almost instinctively, the “unemployment concern” manifested itself. Monetary policy turns highly expansionary with spending reaching 14% growth. Inflation rises but quickly recoils somewhat, probably reflecting a dissipation of the 1979 oil shock. Unemployment remains elevated.

In the first leg of the second stage, the Fed “goes for broke”. Spending growth is forcefully contracted, inflation falls significantly and unemployment shoots up.

It appears that with those actions “Fed credibility” was obtained because with the end of the deep recession in November 1982, the Fed “pumped on the gas” and the recovery was immediate and robust, with both inflation and unemployment dropping significantly.

The indications are that by mid-1982 the market had “bought” the vision of future stability. After 17 years moving sideways with a lot of volatility in nominal terms and plunging in real terms, over the next 17 years it was a “glorious bull market” in both nominal and real terms.

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