Volcker's War on Inflation — The Price of 20% Rates
There's no free lunch in taming prices. In the early 1980s, the Fed raised rates to 20% to break inflation, and the price was the worst unemployment since the Great Depression.
The War Against Double-Digit Inflation
Through the two oil shocks of the 1970s, U.S. inflation soared to about 14.8% in 1980. When prices rise by double digits each year, the value of money melts away fast, and the real purchasing power of savings and wages collapses.
Paul Volcker, who became Fed Chair in 1979, chose forceful tightening out of the conviction that "if you can't tame prices, the whole economy sickens."
Raising the Policy Rate to 20%
Volcker's Fed pushed the federal funds rate up to about 20% in March 1980. It then kept the effective rate at ultra-high levels around 20% into 1981 as well. By making the price of money extremely expensive, it crushed overheated demand and inflation expectations.
It worked. Inflation, about 14.8% in 1980, came down fast to about 6.1% in 1982 and about 3.7% in 1983.
"Real rate = nominal rate − expected inflation." Volcker kept the nominal rate far above inflation to make the real rate strongly positive, and this was the key to breaking inflation expectations.
The Price: The Worst Unemployment Since the Great Depression
The price of taming inflation was harsh. A deep recession dragged on for 16 months from July 1981 to November 1982, and unemployment rose to about 10.8% by late 1982. This was the highest level since the Great Depression at the time.
Volcker faced fierce protests from those hurt by high rates, such as farmers and builders. But many credit him with laying the foundation for the price stability and long-term growth of the mid-1980s onward by enduring this pain. It's a case that showed price stability always comes at a price.
Frequently Asked Questions
Q. Does simply raising rates tame prices?
Raising rates makes borrowing more expensive, reducing consumption and investment and ultimately pressing down demand to slow price increases. However, in that process, the economy and employment can shrink together. Volcker's case shows that "to tame prices for sure, you may have to accept a considerable sacrifice in the economy."
Q. Could Volcker-style ultra-high rates happen again?
Future policy can't be predicted. That said, the Volcker case became a reference point that later central banks take as a lesson: "neglecting inflation expectations leads to a bigger cost." Extreme rates like 20% were the product of a situation where inflation was that severe.
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