The incredible Volcker disinflation

Abstract

The reduction in inflation that occurred in the early 1980s, when the Federal Reserve was headed by Paul Volcker, is arguably the most widely discussed and visible macroeconomic event of the last 50 years of U.S. history. Inflation had been dramatically rising, but under Volcker, the Fed first contained and then reversed this process. Using a simple modern macroeconomic model, we argue that the real effects of the Volcker disinflation were mainly due to its imperfect credibility. In our view, the observed upward volatility and subsequent stubborn elevation of long-term interest rates during the disinflation are key indicators of that imperfect credibility. Studying transcripts of the Federal Open Market Committee recently released to the public, we find—to our surprise—that Volcker and other FOMC members likewise regarded the long-term interest rates as indicative of inflation expectations and of the credibility of their disinflationary policy. Drawing from the transcripts and other contemporary sources, we consider the interplay of monetary targets, operating procedures, and credibility during the Volcker disinflation.

Introduction

In August 1979, when Paul Volcker became chairman of the Federal Reserve Board, the annual average inflation rate in the United States was 9%. Inflation had risen by 3 percentage points over the prior 18 months and there were indications that it was poised to continue to rise (as it did, rising to a peak of 11% in early 1980). The Fed had pursued restrictive monetary policy to stabilize inflation on a number of occasions in the prior two decades but, each time, inflation moved higher shortly thereafter. Against the backdrop of a volatile international and domestic situation in the early 1980s, the Fed brought the inflation rate down to 4% by the end of 1983. During this period, the U.S. experienced two recessions generally attributed to disinflationary monetary policy, the 1981–1982 recession exhibiting the largest cumulative business cycle decline of employment and output in the post-World War II period.

The “rise and fall” of inflation in the post-war period, and the Volcker disinflation in particular, are central events that attracted many economists to macroeconomics and have been the subject of a huge body of research. We first met Bennett McCallum in the late 1970s and have discussed these events many times during a friendship of a quarter century. In these conversations, Ben always stood for three practices: a careful review of the macroeconomic facts, the elaboration of small forward-looking linear macroeconomic models linking the core variables in macroeconomics, and an appraisal of events in light of these models. In this paper, we study the Volcker disinflation using this approach.

We think of the disinflation as “incredible” in three senses. First, looking backward, Volcker initiated a change in the average rate of inflation that has been large and sustained, so that the inflation peak in early 1980 stands out dramatically in the U.S. experience shown in Fig. 1. Second, relative to the perspectives of many contemporary observers in 1978, including ourselves, it is remarkable that a reduction in inflation took place since inflation seemed to be a permanent feature of the U.S. economy at the time and the costs of reducing it seemed so large. Third, we believe that “imperfect credibility of monetary policy” was a core feature of the disinflation on several dimensions that we highlight further below.

Prior to the disinflation, most economists thought that there would be large and protracted output losses from reducing the long-term rate of inflation in the United States. Notably, Okun (1978) surveyed six macroeconomic Phillips curves with two common features: (i) “all$\dots$are essentially accelerationist, implying virtually no long-run trade-off between inflation and unemployment,” and (ii) “all point to a very costly short-run trade-off.” Specifically, Okun reported that the average estimate of “the cost of a 1 point reduction in the basic inflation rate is 10 percent of a year's GNP, with a range of 6 percent to 18 percent.” Thus, if it had led to a downturn lasting four years, the 6 percentage point reduction in inflation engineered by the Volcker Fed would have led to a modern Great Contraction, with output averaging 9–27% below capacity for a total loss of 36–108%.

In fact, the real consequences of the disinflation were sharply smaller than Okun's predictions. Fig. 2 shows the decline in inflation and in real activity during the Volcker disinflation, which involves a cumulative output loss of about 20% according to traditional calculations. While far less than predicted, the output losses were substantial by the standards of post-war U.S. history and had great effect on the lives of many individuals during the period, as we recall from discussions with friends, relatives, and neighbors. It is now fairly standard for macroeconomists to suggest that the Volcker disinflation had a lower than predicted real output cost precisely because of Volcker's credibility.

By contrast, we think that the reduction in inflation engineered by the Fed under Volcker was accompanied by substantial output losses precisely because it was viewed as not credible, in the sense that firms and households believed for several years that the reduction in inflation was temporary with a return to high inflation likely.

Imperfect credibility in a macroeconomic model: We build a very simple macroeconomic model of the Volcker disinflation which attributes all output costs to imperfect credibility. To match the actual decline in inflation, which takes place from 1981 through 1983, our model assumes that inflation declines gradually and cumulatively by 6 percentage points over 10 quarters. The economic actors in the model economy, however, think that there is a possibility that the disinflation program will be abandoned and that inflation will return to the level prevailing at the start of the program. Specifically, we assume that the probability of a successful disinflation is zero for the first year of the program and rises linearly thereafter. With these two elements—a gradual disinflation and a gradual increase in the likelihood of a permanent, major reduction in inflation—the model generates an output decline which resembles the 1981–1983 experience in broad form: a gradually intensifying decline in output, relative to capacity, which reaches a trough after two years and then gradually recovers. The imperfect credibility built into our model also implies very stubborn inflationary expectations which are reflected in elevated long-term interest rates.

Imperfect credibility within our interpretative history: Our historical analysis highlights two important indicators of imperfect credibility. First, the behavior of intermediate and long-term interest rates is evidence that the disinflation was incredible. For instance, while inflation fell from over 10% in early 1981 to under 6% by mid-1982, the 10-year bond rate actually increased from around 13% to over 14% as shown in Fig. 3. We interpret this evidence as indicating that financial markets expected high inflation to return. Second, the transcripts of the Federal Open Market Committee indicate that Volcker and other FOMC members thought that acquiring credibility for low inflation was central to the success of their disinflation. Moreover, they regarded long-term interest rates as indicators of inflation expectations and of the credibility of their disinflationary policy. The FOMC viewed the private sector as profoundly skeptical of its inflation-fighting policy actions and, as the recession deepened, they worried that the public would expect a monetary policy “u-turn.” The FOMC recognized that such skepticism was understandable given its own past behavior.

Our historical analysis also stresses that the Volcker disinflation did not really start in earnest until late 1980 or early 1981. The policy actions of the Volcker Fed in 1979 and 1980, including the celebrated October 1979 announcement of new operating procedures with greater emphasis on money, merely contained inflation in the face of sharply rising inflation expectations evident in bond rates in early 1980. The Volcker Fed's initial inflation-fighting effort was abandoned in mid-1980 with the onset of credit controls and a recession that we believe was brought on in part by restrictive monetary policy. Like some members of the FOMC at the time, we believe that this policy reversal likely hurt the Fed's credibility and thereby contributed to the ultimate costliness of the disinflation of 1981–1983. By November 1980, inflation was still running at an annual rate of over 10%. The Volcker Fed had behaved in a manner consistent with prior experiences. It had undertaken restrictive monetary policy in the face of rising inflation, but it had promptly reversed field to fight the recession and allowed inflation to continue to rise.

In our view, the “deliberate disinflation” dates from late 1980 when the federal funds rate rose to 19% as a result of restrictive monetary policy in conjunction with a strong recovery from the recession. This time, the move against inflation was sustained. Rising inflation expectations—again evident in bond rates in 1981—convinced the Fed to move decisively to reduce inflation. Volcker and other FOMC members viewed the restoration of Fed credibility for low inflation and the associated real cost of a deliberate disinflation in 1981–1982 as necessary to prevent future recessions and inflation scares.

Much has been made of the Volcker disinflation as a grand “monetarist experiment.” However, on its own initiative and under the prodding of congressional committees, the Fed had begun to state money growth targets in the early 1970s. These gradually assumed a more prominent role in the FOMC and in popular policy discussions prior to October 1979. Beginning in 1975, Fed presentations to congressional committees included money target ranges; increasingly, at these hearings and in other commentaries the Fed was criticized for missing its monetary targets. The Fed continued to manage the federal funds rate closely prior to October 1979. However, the narrow tolerance ranges for the federal funds rate in FOMC policy directives did not prevent the Fed from raising the funds rate aggressively on occasion, especially in 1973 and 1978. The October 1979 change in operating procedures placed more emphasis on targeting money, in part by allowing dramatically wider federal funds rate tolerance ranges in FOMC directives. The FOMC transcripts indicate that the October 1979 shift in operating procedures was undertaken initially to improve the Fed's inflation-fighting credibility in order to contain rising inflation expectations.

The organization of the paper is as follows. In Section 2, we introduce and describe our model of inflation and output dynamics. In Section 3, the main body of the paper, we undertake our interpretative history utilizing four types of information. First, we use macroeconomic data—as currently revised—to describe the broad history of the economy immediately preceding and during the Volcker disinflation. Second, we use the implications of our small macroeconomic model. Third, we use FOMC transcripts, briefings of staff economists at FOMC meetings, and annual summaries of FOMC decisions produced by economists at the Federal Reserve Bank of St. Louis. Fourth, we use information from the World Almanac, which reflects contemporary perceptions of major events. In Section 4 of the paper we consider the interaction of monetary instruments, targets, and credibility with the help of the transcripts and other contemporary sources. In the final section, we offer brief concluding comments.