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Paul Volcker, RIP.

Most central bankers prefer to toil in obscurity as they tinker with the levers of monetary policy, particularly given the potential for political backlash inherent in their endeavors. A few Federal Reserve Chairmen have virtually become household names: Alan Greenspan for presiding over the “great moderation” of the 1990s, and Ben Bernanke for his heroic efforts to stem the financial crisis of 2008. But in terms of direct impact on every American, no Fed leader stood taller (literally and figuratively) than Paul Volcker, who died last week at age 92. His passing should be noted especially by the generation that followed for whom “inflation” is a foreign concept.

Notoriously taciturn, the 6 foot 7 inch economist wore rumpled suits and was typically swathed in cheap cigar smoke (his inherent frugality informed both his personal and policy preferences). Volker’s lasting legacy is his spectacular slaying of the inflation monster that undermined US stability in the late 1970s.

When the US officially unmoored the Dollar from the gold standard in 1971 (a necessary but consequential action), inflation picked up steam. Throughout the decade, prices increased relentlessly as the dollar lost value. Annual inflation rates soared to double digits, threatening the economic health of the country and devastating retirees living on fixed incomes. The weakening dollar also crippled the bond market and made government borrowing so difficult that President Carter was forced to issue US Government bonds denominated in Swiss Francs and German Deutschmarks (so-called “Carter Bonds”).

The problem was rooted in a shift in expectations: everyone expected prices to rise sharply in the future, and so behaved accordingly. Union labor contracts, for example, included aggressive annual cost of living clauses that reinforced those inflationary expectations. So too with lenders: banks imputed a steepening inflation premium into their lending rates. These built-in expectations contributed to what became known as “structural inflation”, a self-reinforcing presumption of inflation that was baked into the cake in advance.

By 1979, annual inflation averaged 12% and briefly hit 13.5% in December. To provide an illustration, 12% inflation would cause prices of food, cars and clothing to double in just six years. At today’s 2% rate, it would take 35 years for prices to double. That is the imbroglio into which Paul Volcker agreed wade when he was appointed in 1979.

Volcker understood that there was no easy solution; the medicine would be bitter and must be administered unflinchingly. The new Fed Chairman set out to manufacture an economic recession to subdue runaway prices. In a major shift, the Fed moved to sharply curtail the growth in the money supply, essentially idling the printing presses. The market reacted predictably, by bidding the rate of interest sharply higher and choking off borrowing to slow the economy. By April of 1980, the effective Federal Funds rate had reached a whopping 18% and set in motion the steep recession of 1981. Unemployment hit 10.8% and farmers were parking tractors in front of the Fed in protest. But it worked. Inflation started to retreat.

By 1982, the Consumer Price Index had been halved to 6%. Confidence in the US Dollar began to return. And a new era of prosperity commenced that has lasted (with two interruptions) through today. By 1992, inflation was halved again, and today it stands at a healthy 2.1%.

Both Presidents Carter and Reagan deserve mention for appointing (and reappointing) the Chairman in the face of incredible political pressure (an outcome somewhat removed from our current state). Yet it is Paul Volcker who saw the necessary path and followed it relentlessly and courageously during his 10-year tenure. RIP.

Christopher A. Hopkins, CFA

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