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Deliberate Recession ends Inflation

People are constantly talking about a Covid-19 triggered recession these days and how the Indian Economy is suffering. People have long been afraid of the word Recession, even though most people don’t understand it fully.

But in the 1980s a man brought on a deliberate recession. To end inflation.

Today we bring to you the story of Paul Volcker and his deliberate recession.

(Source: Wikipedia)

Paul Volcker became the chairman of the Federal Reserve Board (US’ central banking system) in 1979. The first problem he faced was inflation. A 9% inflation rate expected to go up to 11% by 1980s.

Quick Note: This inflation was caused when President Nixon ended the gold standard in 1973. This led to a decline in the value of the dollar, making imports expensive and leading to inflation. This was a weird period. Fed Chair Alfred Hayes tried to fight inflation and recession at the same time as he alternately raised and lowered interest rates. Then in 1972, Nixon ended the wage-price controls (https://www.britannica.com/topic/wage-price-control). Companies raised prices because they were vary of high interest rates in the future and confused customer’s just bought more and more again stoking inflation.

People could not understand the Fed’s actions and they were fast losing credibility.

At such a moment came Volcker and he made lowering inflation the prime concern of his policy.

Volcker made contractionary monetary policy his concern and his major move was raising the Federal Fund’s rate (basically, the interest rate that banks charge other banks for lending to them cash overnight, from their reserves). So, the Federal Fund’s rate which had averaged around 11% before 1979 was raised to 20% in June 1981. Apart from this, the prime rate (the rate at which banks lend to the customers with a high credit rating) also rose to 21.5% in 1981. Seeing this, the Keynesian economists who always believed that the current inflation rate depends on the unemployment rate and on lagged inflation, (read about the Phillips Curve to know more) went crazy thinking that the government had gone crazy.

But Volcker’s methods worked. And inflation reduced. Around June, he even lowered the fed rates again but when the inflation again started seeping through the cracks, he raised them back again and kept them above 16% until May 1981. Without his bold change in monetary policy and his determination to stick with it through several painful years, the U.S. economy would have continued its downward spiral. This move is known as the Volcker Shock and is one of the biggest macroeconomic events in recent US history.

Central bankers are realizing the importance of managing inflation expectations, all due to Volcker’s bold policies. As long as people thought that prices would continue to rise, they have had the incentive to spend. The additional demand drove inflation even higher. When consumers realized Volcker would end inflation, they stopped spending. For the same reason, the businesses stopped raising prices.

The economic conditions were almost scary then. The days of "easy credit" turned into the days of "very expensive credit." The prime lending rate exceeded 21 percent. Unemployment reached double digits in some months. The dollar depreciated significantly in world foreign exchange markets. Volcker's tough medicine led to not one, but two, recessions before prices finally stabilized.

Volcker’s methods were like those of a strict but a good teacher. Because curbing inflation which was a mere 1 percent in 1965, and had hit 14 percent by 1980 was not an easy task. In those days he faced a lot of public backlash and criticism. Now, the world regards him as one of the best things to have happened to the US then.

About the Author

Prachi Singh is currently pursuing her MBA from IIM Indore. She writes on her own blog Three Minutes where she ensures you never miss out on handpicked content, ranging from news updates to case studies. You can check it out at https://www.3minutereads.com/

The views and opinions expressed in this article are those of the authors and do not necessarily reflect the official policy or position of any other agency, organization, employer or company.

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