Volcker’s Legacy, Powell’s Future

By in
Volcker’s Legacy, Powell’s Future

Today’s Data section is a bit more of a “Story Time”, but the subject – inflation and US central bank policy – is still very much a numbers-based analysis.

We want to begin with a Paul Volcker (Fed Chair from 1979 to 1987) quote from an interview he gave in 2000. When asked why inflation was not just bad for economies but also a “moral issue”, he said:

“It corrodes trust, particularly trust in government. It is a governmental responsibility to maintain the value of the currency that they issue. And when they fail to do that, it is something that undermines an essential trust in government.”

That clear-eyed approach to monetary policy is one reason Volcker remains the most respected central banker of the modern era; the other is that he acted on his convictions. The chart below shows the story all of us know like the back of their hand.

  • Volcker became Fed Chair in August 1979. The vertical line down the middle of the chart marks that date.
  • From 1970 to 1979, Fed Funds (red line) were never far above CPI inflation (blue line). This policy approach was clearly insufficient to ward off structural inflation. CPI readings trended higher as the decade progressed.
  • After Volcker took the Fed helm, Fed Funds ran far higher than CPI inflation for his entire tenure. Especially notable is the wide gap in 1981 – 1982, when he kept rates very high (10 – 19 percent) even as inflation was clearly in decline. This policy caused a recession (gray bar), but it also had the effect of quickly reducing inflationary pressures.

It is hard to overstate the effect Volcker’s Fed had on the US economy and capital markets:

  • Taming inflation in the early 1980s led to ever-declining interest rates, a long run trend that continues to this day.
  • US equities compounded at 18 percent annually from 1980 – 1999, a record back to World War II.
  • This gave rise to the original dot com bubble in the late 1990s, true. But that period also saw the birth and growth of the Internet, funded in no small part by lofty equity valuations and plenty of low-cost equity capital.
  • The world today would look very different if Paul Volcker had not run Fed policy the way he did 40 years ago.

On top of this, the Volcker Fed gave central bankers a playbook they know markets will take seriously: if inflation becomes a threat, raise interest rates until it diminishes. Current Fed Chair Powell refers to this fact frequently, even if he does not mention Volcker by name.

As strong as this narrative may be, there are two points in the historical record represented by the CPI line in the chart above that merit deeper analysis:

#1: The role Energy prices played in 1970s inflation, especially in terms of how they affected US gasoline prices. There were 2 oil shocks during this period, the first in 1973 with the Saudi oil embargo and the second in 1979 due to the Iranian Revolution. The price of a barrel of oil went from $1-2/barrel (not a typo) in 1970 to $40/barrel in 1980.

As the chart below of the gasoline component of the CPI shows, Paul Volcker could not have picked a better time to be an inflation-fighting Fed Chair. Oil prices peaked in November 1980 at $40/barrel and went pretty much straight to $10/barrel in 1986. Gasoline prices followed the same trend, and inflation for this key commodity dropped from +60 percent a year to zero in less than 2 years. It stayed there until 1986, when it went negative. While gas is only 5-6 percent of headline CPI, it has a flow-through effect throughout the economy and is also a key component of how consumers and businesses “feel” macro price levels.

#2: The calculation of Shelter inflation changed dramatically during Volcker’s tenure. The chart below shows Shelter inflation across the same timeframe as the 2 prior graphs. Shelter is always the single largest component in CPI, so it fundamentally informs headline and core inflation readings.

Until January 1983, the CPI used a measure of Shelter inflation that estimated the price of housing including borrowing costs. These were, of course, extremely high in the late 1970s since 10-year Treasuries yielded +10 percent. Shelter inflation peaked in June 1980 at 21 percent (also not a typo).

In January 1983, the BLS changed the housing component of CPI Shelter inflation to the current survey-based measure called “Owners’ Equivalent Rent”. As the chart shows, Shelter inflation stopped being anywhere near as volatile after that change.

Takeaway (1): while Paul Volcker certainly did a great job as Fed Chair, he had a lot of help from lower oil prices. It also did not hurt that the definition of Shelter prices changed, reducing the chance that a sudden spike in yields could alter public perception of inflation trends. That ended up being irrelevant, but it did take one concern off the Fed’s plate.

Takeaway (2): the analogy to today is twofold. First, supply chain disruptions are this era’s version of the 1970s oil shocks: a sudden event that fundamentally changes price levels. Second, oil prices themselves remain an important input into corporate cost structures and how consumers perceive inflation. Will Chair Powell be as lucky as Chair Volcker and see both issues fade in the next 12-18 months? No way to know, but we’re sure Powell hopes that is the case. If they do not, he may have to travel Volcker’s path and create a recession to tame inflation.

Final thought: all this is a reminder that just because a few lines on a chart, no matter how well-sourced they may be, seem to indicate cause and effect does not mean the data has sufficient integrity to draw a solid conclusion. The composition of the US Consumer Price Index has changed considerably over the decades. So have gasoline prices. Volcker was both very good and very lucky.


PBS Interview with Paul Volcker: https://www.pbs.org/wgbh/commandingheights/shared/minitext/int_paulvolcker.html