The Fed should emulate Volcker’s inflation-fighting tactics

The author is a former chairman of the US Federal Deposit Insurance Corporation and a senior fellow at the Center for Financial Stability.

US Federal Reserve Chairman Jay Powell expressed deep admiration for Paul Volcker, his legendary predecessor, who beat the high inflation that plagued the US economy from 1965 to 1982.

Then, as now, Volcker fought for more than a decade of loose monetary policy coupled with supply shocks driven by geopolitical upheavals. But while he praises the man, Powell deviates from Volker’s methods. Perhaps that is why inflation continues to accelerate, currently exceeding 9% in the US and spreading rapidly around the world.

While Volcker fought inflation by holding back money growth, Powell favored aggressively raising interest rates. He also seems ready to cut rates if we enter a recession. The recent bond rally and the Fed’s own bank stress tests support this view. But Volcker had to pursue tight monetary policy through two recessions to finally beat inflation. If he wants to tame inflationary expectations, Powell must convincingly show that he is willing to do the same.

Each year, the Fed puts the nation’s largest banks under stress tests to determine whether they can withstand adverse economic conditions. The worst-case scenario tested by the Fed this year was a deep recession that would send consumer prices down from 8.25% to 1.25% and send short-term interest rates to zero.

But the Fed hasn’t tested the scenario that most worries many experts: the economy plunges into a deep recession, but consumer prices and interest rates remain high. This was exactly the real-world “stagflation” scenario that Volker faced when he became Fed chairman in 1979, and that we should all be thinking about now.

Volcker maintained tight monetary policy during the recessions of 1980 and 1981-82 despite populist uprisings, bipartisan demands for him to be fired, and even a public call by the US Treasury Secretary to ease the money supply, which he famously dismissed as an “unusual message” . During this time, unemployment rose to double digits, but it held out until inflation finally fell from over 14.8% in 1980 to under 5% by the end of 1982.

His predecessors pursued a “stop and go” policy, continually raising rates when unemployment fell and lowering them again when unemployment rose. This undermined the credibility of the Fed, hit the markets and further strengthened inflation in the economy. Volker wisely and boldly refused to revert to this tactic.

Given this history, it would be foolish for Powell and the Fed to embrace stop and go again today. They should also follow Volcker’s lead by limiting the money supply. At the heart of this and every moment of inflation is too much money chasing too few goods and services.

Unfortunately, while the Fed started raising rates in March, it waited until June 1st to start moving excess money out of the system. He announced that he would be reducing his $8.4 trillion domestic portfolio by $47.5 billion each month, but as of July 13, it had only shrunk by about $28 billion.

Both Powell’s approach to raising rates and Volcker’s approach to limiting the money supply lead to a tightening of monetary conditions. But the current approach is about the Fed, not the markets. The Fed sets rates and makes judgments about the size and pace of the increase. He then implements his policy by increasing the interest rate he pays to large financial institutions so that they keep their money in the central bank instead of lending it out.

For banks, this means higher rates on their reserve accounts with the Fed. For other financial intermediaries, such as money market funds, this means higher rates on certain short-term treasury transactions, called “reverse repos.” These institutions will be reluctant to lend unless their expected return exceeds the risk-free rate they receive from the Fed. The Fed’s bill for this interest is high and rising. At the end of June, a rate of 1.55% was paid on reverse repo balances, and 1.65% on reserve balances. (if only we could all get those bets in our bank accounts).

In contrast, to get money out of the system, the Fed simply sells some of its securities or gives them a maturity without reinvesting the proceeds. This leads to higher rates as private investors become more dominant in the markets the Fed is leaving. It is important to note that it is the markets, not the government, that drive the rate hike. This avoids the appearance and excessive costs of the Fed, essentially paying institutions for not lending.

For years, the Fed has unwisely paid little attention to the vast amount of money its accommodative policies have created. Now he needs to follow Volcker’s example and attack the excess money supply decisively. He should replace the shock and awe of a large interest rate hike with new money-supply targets and aggressively shrink his portfolio, selling at a loss if necessary.

It must also conduct new stress tests to reassure the public that banks can withstand severe stagflation. We’re lucky that Powell is a bold leader – now he should also reflect Volker’s strategic prowess.