What would Paul Volcker do?

Paul Volcker is widely acknowledged as the premier inflation fighter in Federal Reserve history. 

 When President Carter nominated him to be Fed Chair in July 1979, Volcker knew he faced a daunting task. Inflation was 11 percent, inflicting pain on financial markets and economic performance, and the second oil shock was unfolding. The Fed’s lack of inflation-fighting credibility had generated severe currency devaluation and a U.S. dollar crisis in late 1978. 

At his confirmation hearings before the Senate Banking Committee, Volcker made his views clear. The Fed would have to clamp down on monetary policy to reverse the damaging upward price-wage cycle and wring out inflationary expectations. To his credit, Carter supported Volcker, even though he knew it may cause a recession, as did President Reagan.    

Volcker took heat when the Fed sent rates soaring and the economy incurred back-to-back recessions. But in the ensuing decades of moderate inflation and healthy performance, Volcker’s reputation as a wise and trusted policymaker grew, and his sound judgment was sought by every U.S. president and many global leaders.  

So, in the current situation, what would Paul Volcker do?    

Volcker would quickly surmise that inflation is undesirably high, similar to the inflation of the late 1960s but less severe than the late 1970s. The Fed would be required to tighten monetary policy — raising rates and unwinding a portion of the Fed’s balance sheet — but by how much? Volcker would keep his eye on the Fed’s longer-run objective of low inflation as the foundation for sustained economic expansion and maximum employment. He would apply lessons learned from the past, in both policies and communications.   

Like the 1960s, current inflation involves excess aggregate demand generated by fiscal and monetary stimulus. Inflation in the 1960s was driven by the surge in federal spending for President Johnson’s Great Society programs and the Vietnam War and the Fed’s unwillingness to raise rates sufficiently under intense pressure from LBJ. While current deficit spending and monetary expansion in response to the pandemic are magnitudes higher than in the 1960s, a key difference is the current supply shortages that have accentuated price increases.   

Volcker would acknowledge that the Fed’s inflation forecasts are unreliable and assess the underlying rate of inflation in the absence of the supply bottlenecks. Based on the big mistakes of the 1970s, Volcker would politely but firmly brush aside the Biden administration’s arguments that inflation is due to greedy big business and threats of price controls and regulations to tame inflation. Such arguments would be eerily reminiscent of statements by Fed Chairman Arthur Burns in the 1970s and the disastrous wage and price controls.   

While inflation is well below the double-digit inflation of the late-1970s and does not require such aggressive tightening, Volcker would acknowledge several key challenges. First, the Fed funds rate is far below inflation and the gap must be closed by rate hikes. The Fed’s negative real policy rate through most of the second half of the 1970s fueled easy money and the wage-price spiral. Second, the growing chorus of complaints about the Fed’s inflation-fighting credibility must be reversed head-on with policy action, not just a pivoting of forward guidance. Third, with housing booming, the Fed’s massive holdings of mortgage-backed securities are economically irrational. 

Other successful Fed chairs would share these views. In 1994, with inflation at 3 percent and the economy beginning to overheat, Fed Chairman Alan Greenspan moved aggressively, raising rates from 3 percent to 6 percent in a 12-month period. Inflationary expectations subsided, the economy temporarily slowed without going into recession and the robust economic performance of the second half of the 1990s ensued.   

A central debate in monetary policy has been whether the Fed should use full discretion or rules as guidelines for conducting policy. The Fed has coveted its discretion, but its discretionary policies have led to occasional but very costly mistakes. Volcker was not a rules-based policymaker, but he would fully understand what the two rules are now saying.    

First, the Fed’s policy rate should be above inflation. The Fed estimates a neutral rate to be 0.5 percentage points above inflation. Second, the Taylor Rule, which the Fed includes in its semi-annual reports to the Congress, posits that to reduce inflation to its 2 percent target, the Fed should set rates well above the deviation of inflation from 2 percent and also adjust rates to the deviation of real GDP growth from its potential, or alternatively, the deviation of the unemployment rate full employment.  With inflation high and the unemployment rate at 4.0 percent, the Taylor Rule signals the need for aggressive tightening.   

Whatever the benchmark, Volcker would have to assess the underlying rate of inflation. His starting point might be that half of the current inflation is due to excess demand and half due to supply bottlenecks and higher oil prices. Conservatively, that would imply inflation around 3.75-4 percent, halfway in between surveys of inflationary expectations and alternative measures of inflation by the New York and Cleveland Feds. 

Raising rates to any point below that range would be insufficient to interrupt the wage-price feedback and restore the Fed’s inflation-fighting credibility. Currently, the Fed projects its policy rate at 1.6 percent at year-end 2023, but this would sustain negative real rates. Instead, following the Fed’s misguided delays, a rate increase at each of the Fed’s seven remaining meetings this year and every meeting in 2023 is now more appropriate. And the rate increases would be complemented by a balance sheet reduction that involves runoff of maturing assets plus some outright sales of mortgage-backed securities.