What Happened
By 1979 US inflation had been elevated for a decade — fueled by the 1973 and 1979 oil shocks, fiscal deficits, and a Fed that accommodated inflation rather than fighting it. Jimmy Carter appointed Paul Volcker as Fed Chairman in August 1979. Volcker began the most aggressive monetary tightening in Fed history.
On October 6, 1979 — the Saturday Night Massacre — Volcker announced a shift to monetary aggregate targeting rather than interest rate targeting. This allowed rates to rise as high as needed without the Fed directly setting the rate. The Fed funds rate reached 20% in June 1981.
Two recessions followed. Unemployment hit 10.8%. Farmers drove tractors to Washington to protest. Congress held hearings. Politicians from both parties demanded Volcker ease. He did not. By 1983 inflation had fallen to 3.2%. The credibility gained launched a 40-year era of low inflation. Volcker is widely considered the greatest central banker of the 20th century.
The Mechanism
Breaking inflationary expectations through credible commitmentInflation becomes entrenched when workers and businesses expect it to continue. They demand higher wages and raise prices pre-emptively, validating the expectation. Breaking this cycle requires convincing everyone that inflation will fall — which requires a policy shock severe enough to be credible. Gradualism does not work because it can always be reversed. Volcker's commitment to monetary targets even at the cost of severe recession was credible precisely because it caused such pain. The credibility was bought with the recession.
What the Consensus Believed
The prevailing view before the reckoning
Inflation could be reduced gradually without a severe recession. The Fed should balance employment and price stability equally. 20% interest rates would cause a depression. The political system would not tolerate the unemployment required to break inflation through monetary policy alone.
What the Record Shows
Half-measures do not break inflation
Every attempt to reduce inflation gradually from 1974 to 1979 failed because it was not credible. Markets and wage-setters assumed any tightening would be reversed when unemployment rose. Volcker made it clear it would not be.
Political independence enables difficult decisions
Carter appointed Volcker knowing it would cause a recession. Reagan supported the policy despite enormous political pressure to ease. Independent central banking enabled the decision that elected officials could not have made.
The medicine must exceed the disease
The Volcker recession was severe. But the 40-year expansion that followed was far larger than the cost. The present value of stable prices vastly exceeded the short-term pain.
Credibility is the asset
The Fed's inflation-fighting credibility built by Volcker allowed subsequent Chairmen to respond to recessions without inflation expectations becoming unanchored. It is an asset that took years to build and can be lost quickly.
↑ Cognitive pattern: Status Quo Bias — Underestimating the cost of inaction on inflation
Key Voices
Called It Right
Paul Volcker
Federal Reserve
“Inflation is a thief. If we do not break the back of inflation now the cost will be much higher later. I will raise rates as high as needed.”
October 1979 Right — succeeded
Milton Friedman
Chicago
“The cure for inflation is always and everywhere a monetary phenomenon. Only the Fed can stop it and they must be willing to accept the recession.”
1979 Vindicated
Wrong
Congressional critics
Various
“Volcker is destroying the economy with 20% interest rates. Manufacturing is being wiped out. He must ease now.”
1981 Wrong — policy succeeded
Various politicians
Both parties
“The cure for inflation is worse than the disease. The recession will be worse than the inflation.”
1981–1982 Wrong — recovery followed