Monday, September 19, 2011

Paul Volcker Warns On Inflation

In late September, 1979, Federal Reserve Chairman Paul Volcker headed to Europe to confer with his European counterparts.

It was not a pleasant trip. Across Europe, but particularly in Germany, centrals bankers were furious with American policymakers. Inflation was out of control, and the dollar was in a free fall. The Carter administration was perceived as weak and ineffectual, and Volcker was told in no uncertain terms that the U.S. had to get its act together.

Although he was scheduled to stay through the weekend, Volcker flew home earlier to confer with his fellow Fed officials.

Then, on October 4, 1979, Volcker announced that the Fed would no longer target interest rates, but instead focus on money supply. This change in policy - from a Keynesian approach to a monetarist stance - was adopted in a desperate attempt to stop inflation in its tracks.

For the next three years, Volcker withstood fierce political fire and stayed with his monetarist approach. Interest rates soared, however, and the Prime Rate hit 21% at one point. The economy plunged into a deep recession, and unemployment rose over 10%.

But it worked.

Inflation was finally extinguished. The economy and capital markets revived, and the U.S. began to regain its competitive strength. Stocks began the gradual rise which, over the next 17 years, produced the greatest returns for investors in the history of the U.S.

Volcker stayed Fed Chairman until 1987, when he was replaced by Alan Greenspan. However, the courage that Volcker displayed during the early 1980's - supported by President Reagan - was a marked contrast to our political leaders today.

The battle that the Fed and Volcker waged with inflation has largely been forgotten now, or so it seems. Today there are numerous suggestions that, well, maybe a little inflation wouldn't be such a bad thing after all.

Inflation favors the debtor, since debts can be repaid in currencies whose real purchasing power is steadily declining. In a world choked by debt, this has some appeal.

Inflation also raises the value of hard assets such as real estate. With housing mired in a funk that now seems will last for years, inflation has a seductive appeal.

However, as Paul Volcker reminded us this morning in the New York Times, "a little inflation" can be a dangerous tonic:

What we know, or should know, from the past is that once inflation becomes anticipated and ingrained — as it eventually would — then the stimulating effects are lost. Once an independent central bank does not simply tolerate a low level of inflation as consistent with “stability,” but invokes inflation as a policy, it becomes very difficult to eliminate...

At a time when foreign countries own trillions of our dollars, when we are dependent on borrowing still more abroad, and when the whole world counts on the dollar’s maintaining its purchasing power, taking on the risks of deliberately promoting inflation would be simply irresponsible.

Wise words from Mr. Volcker.