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This kind of shock to the economy will have consequences

The rich but largely forgotten history of people protesting high interest rates at the Federal Reserve seems crazy today, when Americans are so used to such easy access to borrowed money.

We’re talking about the late 1970s and early 1980s here, when high inflation became so entrenched in the American psyche that killing it caused a shock to the system, resulting in daily interest rates comparable to those billed by credit cards today.

The inflation cure triggered a double-dip recession — where one recession was followed by a brief recovery, then another recession — and put millions of Americans out of work.

The architect of that shock, former Federal Reserve Chairman Paul Volcker, is today being hailed for doing the politically difficult thing and creating the environment for decades of subsequent economic growth.

But he withstood criticism as inflation waned.

The chairman who put Volcker in charge of the Fed, Jimmy Carter, lost his job amid a crisis of confidence and voter unease. Ronald Reagan would reappoint Volcker for a second four-year term before the two fell out.

The Volcker shock. This week, people are reminiscing about the “Volcker Shock”, which changed the course of the US economy at the time, as the Federal Reserve imposes its second massive rate hike in a row today.

Read these CNN Business articles for the full story of Wednesday’s hike:

Now back to Volcker.

What kind of rate were they considering when Volcker took on inflation?

Mortgage rates have skyrocketed. let’s look 30-year fixed mortgage ratesthat track close to Fed-controlled rates.
The average 30-year fixed rate was already excessive and approached 12% in October 1979, even before Volcker dramatic announcement drastic anti-inflationary measures. In a few months, the average rate had risen to more than 16%. The average 30-year fixed mortgage rate was above 18%, its meteoric peak, in October 1981.
Today, we are still a long way from those peaks of the 80s; 30-year fixed rates have almost doubled in one year to almost 6%.

Volcker’s legacy is impressive. Every story you read about Volcker will mention that he was tall, at 6ft 7in. But he has an outsized legacy to match.

As well as delivering the harsh remedy that ended the runaway inflation of the 1970s, he is credited with the “Volcker rule”, which for a time prevented banks from trading their own assets.

Chris Isidore wrote CNN’s obituary for Volcker in 2019. I asked him how Volcker might view the current fight against inflation.

He made these important points:

Volcker was ready to make tough choices. Volcker believed the Fed should do whatever it takes to bring prices back in line. Under his leadership, the central bank raised its policy rate to 19% in January 1981.

There were consequences. Its policy of high interest rates caused not just one, but two recessions in a short time: one in January 1980 which lasted until July 80, which was followed in a short time by the recession which began in July 81 and ended in November 1982.

In November 1982, the unemployment rate reached 10.8%, almost a percentage point higher than it had reached following the Great Recession 12 years ago.

It was much worse inflation than today. Volcker had far more serious inflationary pressures to contend with, with the rate of increase in the consumer price index peaking at 14.8% in March 1980, well above the current rate of 8.3%.

Volcker faced a price-wage spiral. Far more workers had union contracts than today, and many of those contracts had cost-of-living adjustment, or COLA, clauses that automatically increased wages when prices rose. This is not the case today.

Today, the Fed has less control. Many factors in the current high inflation are beyond the Fed’s control, including the oil and food price spikes caused by the war in Ukraine and the supply chain problems caused by the Covid-19 pandemic, which further increase the cost of production of many products and causing shortages in the face of high demand.

Inflation can become a self-fulfilling prophecy

A big part of the Fed’s job in controlling inflation is to convince people that inflation has been brought under control, according to former Fed official David Wilcox, who is now a senior fellow at the Peterson Institute for International. Economics.

Just before this latest rate hike, he wrote an op-ed for CNN Business, in which he proposed two paths for the United States:

The optimistic view is that people believe inflation is under control. “If households and businesses maintain the view that inflation will return to 2% in the not-too-distant future, the Fed’s task of achieving that outcome will be much easier,” Wilcox wrote.

The pessimistic view is that people think it’s here to stay. “The experience of escalating prices at the gas pump and grocery store over the past year may have conditioned households and businesses to expect the same,” Wilcox wrote. . “In that case, the Fed will have to raise its key interest rate much higher – and the coming economic crisis will be much deeper.”

Wilcox argued that Volcker was trying to drag Americans out of a general acceptance of too high inflation. Today, Wilcox sounds optimistic and predicts that inflation will be lower within a year and in the vicinity of the 2% target within two or three years – although who knows what will happen with the pandemic and the war in Ukraine.

Wilcox refers to Volcker as “the patron saint of inflation control” and notes that current Fed Chairman Jerome Powell often invokes Volcker’s name.

It’s usually in glowing terms. This spring, Powell praised Volcker for fighting on two fronts, “slaying, as he called it, the ‘inflationary dragon’ and dismantling the public belief that high inflation was an unfortunate but unchanging reality.”

Let’s hope that’s not the case and that these interest rate hikes don’t have the same unintended consequences that Volcker did over 40 years ago.