Under Volcker, the Fed finally put its proverbial foot down. Interest rates skyrocketed; businesses that relied on debt financing, including construction and car sales, went under; and the unemployment rate reached 10.8 percent, a level that would not be seen again until the global financial crisis. But it worked: inflation fell from 13.5 percent in 1980 to 3.2 percent in 1983.
This story is usually told triumphantly: the brave Volcker, taking the painful but necessary steps! However, now that our own Fed chairman may face an equally ugly tradeoff, I confess that I am thinking more about the deep pain the recession caused. Of course, it’s bad to lose 8 percent of your purchasing power due to inflation. But it’s even worse to lose 100 percent through unemployment, and the collective suffering of those who lose their jobs is arguably far greater than the pains of households affected 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’s not. “If you were me and you were in charge of monetary policy, would you cause a big recession to keep inflation down? No. But I would try to get to a stable inflation rate and then gradually bring the inflation rate down over time.”
To understand where you’re headed, imagine if you knew that every year, inflation would be exactly 10 percent. That is a very high rate of inflation, but if everyone knew what it was going to be, we would develop ways to mitigate the impact. Interest rates on bonds and savings accounts would rise to offset inflation losses. Employment contracts would specify annual cost-of-living increases of 10 percent. Social security checks and pensions would have similar adjustments built into them.
Now compare that to an unexpected 10 percent, which is close to what we’re experiencing right now. Suddenly everyone’s grocery budget skyrockets, savings lose a lot of their value, and people worry about being able to put gas in the car. That is a completely different phenomenon and much worse, because it makes it impossible to plan our financial lives.
“We haven’t moved to a new equilibrium where the amount of inflation is as expected,” says Huizinga. “That’s the worst kind of inflation because it means we’re making bad decisions every day.” Had we known, we would have implemented mitigation measures. Instead, we face costs that we didn’t plan for.
Now, obviously, it would still have been better to have never had inflation, since those adjustments will be imperfect; someone who invested his life savings in a fixed annuity just before inflation took 8 percent off the value of him is now permanently worse off. Also, the same adjustment mechanisms that help people offset the cost of inflation can make it harder for the Federal Reserve to control inflation. If businesses expect costs to rise 5 percent next year, they will demand higher prices to offset the increase, and if workers expect higher prices, they will demand higher wages, which translates into higher costs for businesses. . When expectations are “unanchored” from monetary policy in this way, inflation feeds back.
But without 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 the Fed can do is to stabilize inflation and then gradually lower it. I just wonder if that is possible. For one thing, it may already be too late to avoid a recession; we have already had a quarter of negative growth. But the biggest uncertainty is whether the Fed could announce a high but stable inflation policy and make it stick.
After decades of credibly maintaining a 2 percent inflation target, could the Fed suddenly announce that it will allow inflation to stay high, but not go any higher? Or would future inflation expectations loosen their anchors and take off into the stratosphere? Would it be politically possible for the Fed to stay that way, with anxious Americans clamoring for Congress to do something (like appoint inflation hawks to the Board of Governors)? It may be that, for all its costs, the Volcker Way is still the best option available to us, given the political constraints, though if so, that’s all the more reason for the Fed to make sure inflation doesn’t just come down but keep it. bass.
“If you ever let inflation start again, who knows how quickly people will start to expect it?” Huizinga says. And no matter how you do it, “breaking that cycle is very expensive.”