Inflation Nation

IN the 1970s, with inflation rising, I often described the Federal Reserve as knowing only two speeds: too fast and too slow. At the time, the Fed’s idea was to combat recession by promoting expansion, printing money and making it easier for businesses and households to borrow — and worry only later about the inflation that resulted. That strategy produced a sorry decade of slow productivity growth, rising unemployment and, yes, rising inflation. If President Obama and the Fed continue down their current path, we could see a repeat of those dreadful inflationary years.

Back then, as now, the members of the Fed were well aware of the harmful effects of inflation. In private, they vowed not to let it get out of hand and several times even started to do something about it. But when their anti-inflationary moves caused the unemployment rate to rise to 6.5 percent or 7 percent, they forgot their promises and again began expanding the money supply and reducing interest rates.

By 1979, reported rates of inflation, worsened by the oil shock, had reached double digits. Opinion polls showed that the public now considered inflation to be the main economic problem. President Jimmy Carter’s choice for chairman of the Fed, Paul Volcker, said that he would fight inflation more deliberately than his predecessors. The president agreed with him, as did the chairmen of the Congressional banking committees.

With the public acceptance of the importance of low inflation, support in the administration and in Congress, and a chairman committed to the task, the Fed finally set out to correct what it had too long neglected. Instead of working only to avoid unemployment, the Fed sought to bring inflation back under control. Instead of flooding the market and banks with money, the Fed tightened its reserves. And instead of keeping interest rates in a narrow, relatively low range, Mr. Volcker let the market dictate the interest rate, allowing the prime rate to go as high as 21.5 percent. These disinflation policies continued in earnest with the 1980 election of Ronald Reagan.

Even so, the public, having already seen three or four failed attempts to tame inflation, didn’t really believe that Mr. Volcker and President Reagan would stay the course. In my reading of the evidence, a decisive change in attitudes occurred only in the spring of 1981, when the Federal Reserve raised interest rates even though the unemployment rate was approaching 8 percent. This was new. This was different. People began to expect lower inflation and, in this belief, slowed the increase in wages and prices, contributing to the decline in actual inflation.

Naturally, there were critics. But their criticisms were not strong enough to reverse policy. At the 1982 convention of the National Association of Home Builders, Paul Volcker said that if he were to let up on anti-inflation efforts prematurely, “the pain we have suffered would have been for naught — and we would only be putting off until some later time an even more painful day of reckoning.” As always in periods of high interest rates, home builders had been especially badly hurt, but when the chairman finished his speech, they gave him a standing ovation. Though they disliked his policy, they admired his determination to do what was needed.

The pain did not end. And the anti-inflation policy continued until the unemployment rate rose above 10 percent, many savings and loan institutions faced bankruptcy, and most Latin American countries defaulted on their debt. These were the unavoidable side effects of the public’s gradual adjustment to the new economic environment. This process continued until 1983, when the reported inflation rate fell below 4 percent.

Paul Volcker is now the head of President Obama’s Economic Recovery Advisory Board. Mr. Volcker and the administration’s many economic advisers are all fully aware of the inflationary dangers ahead. So is the current Fed chairman, Ben Bernanake. And yet the interest rate the Fed controls is nearly zero; and the enormous increase in bank reserves — caused by the Fed’s purchases of bonds and mortgages — will surely bring on severe inflation if allowed to remain. Still, they all reassure us that they can reduce reserves enough to prevent inflation and they are committed to doing so.
By Albert Meltzer
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