Under Volcker, the Fed has finally put its proverbial foot down. Interest rates soared; businesses that relied on debt financing – including auto construction and sales – collapsed; and the unemployment rate reached 10.8%, a level that we will not find before the global financial crisis. But it worked: inflation fell from 13.5% in 1980 to 3.2% in 1983.
This story is usually told triumphantly – brave Volcker, taking the painful but necessary steps! Yet, now that our own Fed Chairman can deal with an equally ugly compromise, I confess that I think more about the deep pain caused by the recession. It is, of course, bad to lose 8% of your purchasing power to inflation. But it’s even worse to lose one hundred percent to unemployment – and the collective suffering of those who lose their jobs is arguably far greater than the pains of households strained by inflation.
So I asked John Huizinga, who taught me macroeconomics 20 years ago at the University of Chicago Booth School of Business: Why is a recession better than high inflation? His answer, in short: It is not. “If it was me and I was in charge of monetary policy, would I cause a big recession to keep inflation low? No. But I would try to achieve a rate of stable inflation, then gradually reduce the rate of inflation over time.
To understand where he is coming from, imagine that you knew that each year, inflation would be exactly 10%. It’s a very high rate of inflation, but if everyone knew what it was going to be, we would find ways to lessen the impact. Interest rates on bonds and savings accounts would rise to compensate for losses due to inflation. Employment contracts would specify annual increases of 10% in the cost of living. Social Security checks and pensions would have similar built-in adjustments.
Now compare that to an unexpected 10%, which is close to what we’re experiencing right now. Suddenly, everyone’s grocery budget skyrockets, savings lose much of their value, and people worry about getting gas in the car. It is a completely different phenomenon, and much worse, because it makes it impossible to plan our financial life.
“We have not moved to a new equilibrium where the amount of inflation is what is expected,” Huizinga says. “It’s the worst kind of inflation because it means we make bad decisions every day.” If we had known, we would have implemented mitigation measures. Instead, we are faced with costs that we had not anticipated.
Now, of course, it would have been even better to never have inflation at all, since these adjustments will be imperfect; someone who invested their savings in a fixed annuity just before inflation took a bite out of 8% of their value is now in worse shape. Moreover, the very adjustment mechanisms that help people offset the cost of inflation can make it harder for the Federal Reserve to get inflation under control. If companies expect costs to rise by 5% next year, they will demand higher prices to compensate for the increase, and if workers expect higher prices, they will demand higher wages. higher, which will translate into higher costs for businesses. When expectations become “unanchored” from monetary policy in this way, inflation feeds on itself.
But in the absence of a time machine, it’s too late not to have inflation. So what to do now?
I agree with my former professor that probably the best thing for the Fed to do is to stabilize inflation and then gradually reduce it. I just wonder if it’s possible. On the one hand, it may already be too late to avoid a recession; we’ve already had a quarter of negative growth. But the biggest uncertainty is whether the Fed could announce a high but stable inflation policy and hold it.
After decades of credibly maintaining a 2% inflation target, could the Fed suddenly announce that it will let inflation stay high, but not higher? Or would future inflation expectations lose their anchors and soar into the stratosphere? Would it be politically possible for the Fed to maintain this course, with anxious Americans demanding that Congress do something (like appoint inflation hawks to the Board of Governors)? It may be that, for all its costs, the Volcker route remains the best option available to us, given the political constraints – although if so, that is all the more reason for the Fed to s ensures that inflation not only gets low, but stays low.
“If you ever let inflation start again, who knows how quickly people will start to expect it?” says Huizinga. And no matter how you do it, “breaking this cycle is very expensive.”
