“This is a testing time: a test not only of our ability collectively to achieve coherent and intelligent policies, but to stick with them.” — Paul Volcker, October 9, 1979
Paul Volcker and his colleagues on the Federal Open Market Committee (FOMC) deserve praise for maintaining their campaign to tighten monetary policy despite the painful recession of 1981-1982. Their actions ended the brutal stagflation that plagued the nation in the latter stages of the Great Inflation of 1965 to 1982. Forty years later, it’s easy to forget that Volcker’s programs were much harder to defend when, in terms of monetary policy, he blazes a trail through the virgin forest.
The United States has suffered devastating depressions and financial panics throughout its history, but there has only been one Great Inflation. Solving this extraordinary crisis required the US Federal Reserve to enact untested policies that all but ensured a deep recession, a sharp decline in asset values, and a painful rise in unemployment.
Volcker spoke to the American Bankers Association (ABA) on October 9, 1979 to win their support for these policies, knowing that his prescription would inevitably lead to short-term pain and hardship. He appealed to his audience’s sense of collective responsibility, acknowledging the extraordinary weight on their shoulders. After all, bankers, financiers and investment professionals are stewards of the nation’s credit, which was repaired by Alexander Hamilton in 1790. The ability to maintain this creditworthiness has fueled the US economy, rescued from economic crises and has protected the nation from foreigners. threats
The persistent inflation that Volcker was trying to eliminate had damaged the country’s economic health. Why was inflation so tenacious in the 1970s? One of the biggest reasons was the collective failure of policymakers to delay gratification. Unwilling to sacrifice his Great Society programs, reduce the conflict in Vietnam, or damage his own reelection prospects, President Lyndon Johnson insisted that the Fed maintain an overly accommodative monetary policy. President Richard Nixon followed a similarly self-interested course and inflation took hold and became endemic. Instead of asserting the Fed’s independence, Fed Presidents William McChesney Martin, Jr. and Arthur F. Burns succumbed to political pressure.
By letting inflation fester for so long, they made it much harder for their successors to tame. Much more economic pain was needed to fix the problem than if the Fed had intervened decisively earlier.
Volcker acknowledged the damage the Fed’s faltering resolve had caused, but vowed to persevere.
“Some would suggest that we as a nation do not have the discipline to deal with inflation,” he told the ABA. “I just don’t accept that view.”
On September 13, 2022, the US Bureau of Labor Statistics reported that the CPI rose at an annualized rate of 8.3%, putting more pressure on the Fed to respond aggressively. When Jerome Powell says that the Fed will continue to tighten until the job is done, I firmly believe that he means it. But it remains to be seen whether the Fed’s actions will match those words over the coming months. The first series of rate hikes and quantitative tightening were relatively painless. The next phase will not be. If the Fed goes ahead, the economy will contract, unemployment will rise and markets will fall. All this pain is necessary to ensure that the current temporary inflationary event does not turn into a repeat of the Great Inflation, which would threaten our long-term prosperity.
During the Panic of 1907, J. Pierpont Morgan realized that the failure of the Trust Company of America would be a fatal turning point that could plunge the country off the economic precipice. Morgan famously declared, “That’s where the problem stops,” and proceeded to orchestrate a rescue. Even after the run on the Trust Company of America was halted, panic continued to spread on Wall Street. Morgan spent the next three weeks gathering support from trusted businesses, national banks, private corporations, politicians, and other interested parties. Together, they pooled their resources and pulled America back from the brink. His timely leadership, combined with politicians’ terror at the prospect of facing a future panic without J. Pierpont Morgan, inspired the creation of the Fed six years later.
Fed leadership now faces a similar tipping point. They will have to decide if they have the resolve to avoid a second Great Inflation. But fighting inflation is not the Fed’s sole responsibility: the time ahead will require everyone to decide whether to hang on to the excessive but unsustainable spoils of the present or sacrifice now to build a richer legacy for future generations. .
I hope we choose the latter.
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All posts are the opinion of the author. Therefore, they should not be construed as investment advice, nor do the views expressed necessarily reflect the views of the CFA Institute or the author’s employer.
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Mark J. Higgins, CFA, CFP
