May 26th 2022

Jerome Powell's Volcker Deficit 

 

NEW HAVEN – Poor Jerome Powell. With US inflation close to a 40-year high, the Federal Reserve chair knows what he needs to do. He has professed great admiration for Paul Volcker, his 1980s-era predecessor, as a role model. But, to paraphrase US Senator Lloyd Bentsen’s famous 1988 quip about his vice-presidential rival, Senator Dan Quayle, I knew Paul Volcker very well, and Powell is no Paul Volcker.

Volcker was the quintessential US public servant. He smoked cheap cigars, wore rumpled off-the-rack suits, and had a strong distaste for the glitz of Washington power circles. His legacy was a single-minded discipline in attacking a pernicious Great Inflation. 

Unlike the modern Fed, which under Ben Bernanke’s intellectual stewardship created a new arsenal of tools – balance-sheet adjustments, special lending facilities, and the “forward guidance” of outcome-dependent policy signals – the Volcker approach was simple, blunt, and direct. Monetary policy, in Volcker’s view, started and ended with interest rates. He once said to me, “If you are not prepared to act on interest rates, you may as well get out of town.”

Volcker, of course, raised US interest rates to unheard-of levels in 1980-81, and there were many who did want him to get out of town. But howls of protest from builders, farmers, citizens’ groups, and members of Congress demanding his impeachment did not dissuade him from an unprecedented tightening in monetary policy.

It was long overdue. Under Volcker’s predecessor, Arthur Burns, the Fed had become convinced that inflation was part of the US economy’s institutional fabric. The price level was thought to have less to do with monetary policy than with the power of labor unions, cost-of-living wage indexation, and regulatory pressures on costs stemming from environmental protection, occupational safety, and pension benefits. Burns argued that oil and food-price shocks reinforced the institutional biases of an inflation-prone US economy. In other words, blame the system, not the Fed. The Fed’s research staff, which at the time included me, squirmed but raised no objections.

Volcker did more than squirm when he took over as Fed chair in August 1979. At the time, the consumer price index was surging by 11.8% year on year, on its way to 14.6% in March 1980. Volcker was determined to find the interest-rate threshold that would break the back of US inflation. Using the political cover provided by the 1978 Humphrey-Hawkins Act, which formalized the Fed’s price-stability mandate, and drawing operational support from a shift to targeting the money supply, Volcker went into action.

The Fed increased its benchmark federal funds rate from 10.5% in July 1979 to 17.6% in April 1980. Volcker then reversed course during an ill-advised but short-lived experiment with credit controls in the spring of 1980, before resuming a monetary-policy tightening that eventually pushed the funds rate to a monthly peak of 19.1% in June 1981. Only then did the fever of double-digit inflation break. 

By late 1982, with the US in deep recession, annual headline CPI inflation had slipped below 4%, and the Fed started to reduce the benchmark policy rate. Mindful of the deeply entrenched inflationary psychology still gripping America, the Fed moved slowly and cautiously. Volcker, having broken the back of inflation, was not about to “leave town” until the Fed’s mission was complete.

Fast-forward 40 years, and Powell’s problem is glaringly apparent. Yes, the world today is certainly different than it was back then. But the modern Fed apparently has no institutional memory of the mistakes that it made in the Burns era. In 2021, there was a striking sense of déjà vu when US central bankers treated the initial surge in inflation as transitory and squandered the credibility of well-anchored expectations of low inflation.

The Fed viewed the COVID-19 shock in the same way it viewed the global financial crisis of 2008-09, and injected massive monetary stimulus to address what it was convinced would be a protracted shortfall in aggregate demand. In retrospect, that was an epic policy blunder. As pandemic-related lockdowns quickly gave way to a reopening of the economy, aggregate demand, aided by massive fiscal stimulus, snapped back with a vengeance. And in the face of now seemingly chronic supply-chain disruptions, this post-lockdown takeoff spawned the great inflation of our generation.

Powell’s problem is all the more evident when viewed through the inflation-adjusted lens of real interest rates. Over the 51 months of his leadership of the Fed (through April 2022), the real federal funds rate has averaged -1.95% (with a stress on the minus sign). This extraordinary monetary accommodation is unmatched in modern times. The real funds rate averaged -0.05% for eight years under Burns, -0.7% during Bernanke’s eight-year tenure, and -0.9% for four years under his successor, Janet Yellen.

Under Volcker, by comparison, the real federal funds rate averaged 4.4% for eight years (with a stress on the positive sign). Moreover, notwithstanding the Powell Fed’s newfound determination to move swiftly to counter what it belatedly views as a serious inflation problem, I suspect that the federal funds rate will remain below the US inflation rate well into 2023. That would push the Powell average down to -2.25% over the 59 months ending in December 2022.

No, I am not arguing that Powell needs to replicate Volcker’s tightening campaign. But if the Fed wishes to avoid a replay of the stagflation of the late 1970s and early 1980s, it needs to recognize the extraordinary gulf between Volcker’s 4.4% real interest rate and Powell’s -2.25%. It is delusional to believe that such a wildly accommodative policy trajectory can solve America’s worst inflation problem in a generation.

Like Volcker, Powell takes his mission of public service very seriously. Unfortunately, as Bentsen might have said, that is where the comparison ends.


Stephen S. Roach, a former Chairman of Morgan Stanley Asia, is a faculty member at Yale University and the author of the forthcoming Accidental Conflict: America, China, and the Clash of False Narratives (Yale University Press, November 2022). 

Copyright: Project Syndicate, 2022.
www.project-syndicate.org 

 


This article is brought to you by Project Syndicate that is a not for profit organization.

Project Syndicate brings original, engaging, and thought-provoking commentaries by esteemed leaders and thinkers from around the world to readers everywhere. By offering incisive perspectives on our changing world from those who are shaping its economics, politics, science, and culture, Project Syndicate has created an unrivalled venue for informed public debate. Please see: www.project-syndicate.org.

Should you want to support Project Syndicate you can do it by using the PayPal icon below. Your donation is paid to Project Syndicate in full after PayPal has deducted its transaction fee. Facts & Arts neither receives information about your donation nor a commission.

 

 

Browse articles by author

More Current Affairs

Apr 13th 2022
EXTRACTS" "Ukraine and Russia produce a substantial amount of grain and other food for export. Ukraine alone produces a whopping 6% of all food calories traded in the international market. At least it used to, before it was invaded by the world’s largest nuclear power." ...... "When it comes to cereals like wheat, corn, rice and barley, the big players talk about millions of metric tonnes, or MMTs. A single MMT of wheat contains about 3.4 trillion food calories,." ....."Ukraine produced about 80 MMT of grain (a category that includes wheat, corn and barley) in 2021, and is expected to harvest less than half of that this year. A shortfall of 40 MMT is enough missing calories that a country like the UK could only make it up by having everyone stop eating for three years. That’s the thing about tonnes of grain: a million here and a million there and pretty soon you’ve got a real issue on your plate."
Apr 11th 2022
EXTRACT: "I don’t even know the little girl’s name. All I do know is what a friend of a friend wrote on Viber: that her relative, a senior nurse in one of Kyiv’s hospitals, “saw in the morgue a child with 20 varieties of sperm on her small body.” Since this information was conveyed in a private conversation, there is no reason to doubt its veracity."
Apr 8th 2022
EXTRACT: "Russian society has so far failed to stop Putin, just as German society failed to stop Hitler. And so, like a poisoned chalice, that task has fallen to the West, as it did in 1939. The West must now treat Putin and his regime the same way that Winston Churchill treated Hitler: Don’t talk to him, just defeat him. Dead-enders such as Putin are too fanatical and desperate to be reliable negotiating partners."
Apr 3rd 2022
EXTRACT: "From 1807 to 1814 on the Iberian peninsula, Napoleon had to fight Spanish, Portuguese and British armies while beset by ubiquitous, ferocious insurgents. He described this war as his “bleeding ulcer”, draining him of men and equipment. It is the west’s aim to make Ukraine for Putin what Spain was for Napoleon. In the absence of a negotiated settlement, Ukraine and Nato will continue to grind away at Russia’s army, digging away at that bleeding ulcer and prolonging Russia’s agony on the military front, as the west continues its parallel assault on its economy. If Putin’s plan is to proceed with the Korea model, he will fail. There is a strong possibility that Putin has only a limited idea of how badly his army is faring. So be it – he’ll find out soon enough that there is now no path for him to military victory."
Apr 1st 2022
EXTRACTS: "Policymakers expected that the country would be able to secure its energy supply entirely from renewable sources, so they resolved to phase out coal and nuclear energy simultaneously. The last three of Germany’s 17 nuclear power plants are set to be shut down this year." ---- ".... the share of wind and solar power in Germany’s total final energy consumption, which includes heating, industrial processing, and traffic, was a meager 6.7%. And while wind and solar generated 29% of the country’s electricity output, electricity itself accounted for only about a fifth of its final energy consumption." ----- "If Germany suddenly halted Russian gas imports, gas-based residential heating systems – on which half the German population, approximately 40 million people, rely – and industrial processes that rely heavily on gas imports would break down....."
Apr 1st 2022
EXTRACT: "For Putin, the past that matters most is the one the dissident author and Nobel laureate Aleksandr Solzhenitsyn exalted: the time when the Slavic peoples were united within the Orthodox Christian kingdom of Kievan Rus’. Kyiv formed its heart, making Ukraine central to Putin’s pan-Slavic vision. ---- But, for Putin, the Ukraine war is about preserving Russia, not just expanding it. As Russian Foreign Minister Sergei Lavrov recently made clear, Russia’s leaders believe that their country is locked in a “life-and-death battle to exist on the world’s geopolitical map.” That worldview reflects Putin’s longstanding obsession with works of other Russian emigrant philosophers, such as Ivan Ilyin and Nikolai Berdyaev, who described a struggle for the Eurasian (Russian) soul against the Atlanticists (the West) who would destroy it. ---- Yet Putin and his neo-Eurasianists seem to believe that the key to victory is to create the kind of regime those anti-Bolshevik philosophers most detested: one run by the security forces. A police state would fulfill the vision of another of Putin’s heroes: the KGB chief turned Soviet General Secretary Yuri Andropov."
Apr 1st 2022
EXTRACTS: "Ukraine, known as the breadbasket of Europe, is struggling to export last year’s harvest, and may be unable to produce much this year either. In addition, the war has caused a global fertiliser shortage, which will push up food prices around the world too. Coming at a time when the global pandemic had already increased food insecurity and depleted resources around the world, many countries may not be resilient to a major food crisis brought on by the war. Back-to-back global catastrophic events like this have not happened for close to 100 years." ----- "Another useful analogue is the case of Germany during the first world war. When war broke out in 1914, the German authorities had anticipated a short conflict – not too dissimilar to Russian assumptions a few weeks ago. Just like in Ukraine now, the first world war severely disrupted German farming."
Mar 31st 2022
EXTRACT: "The horrors of World War II – the death camps, slave labor, and inhumane experiments on people – produced a global commitment never to permit such crimes to be repeated. This began a transformation of international politics whereby appreciation of the value of every person’s life and dignity ensured that even most authoritarian governments at least paid lip service to human rights.  ----- But the Soviet Union and many of its successor states, particularly Russia, never internalized this change. More than three decades after the USSR collapsed, most post-Soviet countries are still governed according to the old “imperial” paradigm. So, it should come as no surprise that we are now witnessing a clash between fundamentally different sets of values and ultimate goals for statehood."
Mar 26th 2022
EXTRACT: "Referencing past legacies as a justification for present-day political decisions is often effective – such appeals trigger emotional reflexes and contribute to thinking about politics in terms of rivalry and defence. The irony within the tragedy of the current situation is that Putin will assuredly go down in history as the figure that did more to unite the Ukrainian people (albeit against Russia) than any other in recent memory."
Mar 24th 2022
EXTRACT: " Despite the death and destruction that Russia rains down daily on them, the vast majority of Ukrainians are bullish about the future: 77% believe the country is moving in the right direction, 93% think they can beat back Russia, and 47% expect to win in the next few weeks.  Ukrainian policymakers are no less bullish, driving a hard bargain in negotiations with the Russians. Several factors account for this remarkable optimism."
Mar 21st 2022
EXTRACT: "As Russia’s war in Ukraine continues, China’s role has been thrown into sharp relief. Prior to the war, some commentators suggested that China would openly side with Russia or seek to act as a mediator – so far Beijing appears to have resisted doing either. As Qin Gang, China’s ambassador to the US, wrote recently in the Washington Post, Beijing has nothing to gain from this war, arguing “wielding the baton of sanctions at Chinese companies while seeking China’s support and cooperation simply won’t work”. Ambassador Qin also stressed that Beijing had no prior knowledge of the conflict,...."
Mar 17th 2022
EXTRACT: "The second source of Russian power is of course the world’s largest nuclear arsenal. Nuclear weapons would not deliver victory in a conventional war, but they could destroy a country in the blink of an eye. This brings us to a terrifying question: What will Putin do when he realizes that he cannot win his war in Ukraine by conventional means?"
Mar 17th 2022
EXTRACT: "An influential Shanghai-based academic commentator on international affairs, Hu Wei, recently advanced a cautionary argument that has been circulated widely in Chinese-language publications. In his commentary, which is unlikely to have been published without the approval of some of Xi’s senior courtiers, Hu wondered how Chinese communists would react if the war escalated beyond Ukraine, or if Russia was clearly defeated." ------- "For Hu, the answer for China’s leaders is simple. They should wash their hands of the relationship with Putin, ....."
Mar 12th 2022
EXTRACT: "Meanwhile, Xi seems to have realized that Putin has gone rogue. On March 8, one day after Chinese Foreign Minister Wang Yi had insisted that the friendship between China and Russia remained “rock solid,” Xi called French President Emmanuel Macron and German Chancellor Olaf Scholz to say that he supported their peacemaking efforts."
Mar 7th 2022
EXTRACTS: "........Russia has been isolated by draconian Western sanctions that could devastate its economy for decades,...." ---- "Russia’s prospects are bleak, at best; without China, it has none at all. China holds the trump card in the ultimate survival of Putin’s Russia."
Mar 3rd 2022
EXTRACT: "Although Ukraine’s armed forces are outnumbered by those of Russian President Vladimir Putin invading our country, we take heart from the growing support we are receiving from friends abroad. Nobody should forget that this is not just an unprovoked invasion of Ukraine; it is an assault on the free world. ---- Putin has been at war with the free world for decades. "
Mar 2nd 2022
EXTRACT: "Moreover, with China sharing the Kremlin’s interest in containing the advance of liberal democracy around the world, Putin could count on the Chinese to provide an additional economic lifeline by purchasing Russian gas. But this new relationship will not be costless. As the world continues to divide into separate technological and economic blocs, Russia will become even more dependent on China, implying a loss of strategic autonomy. Russia may have a powerful military; but with a GDP similar to that of Spain and Italy, it is far from being an economic power."
Mar 1st 2022
EXTRACT: "The financial measures just announced against Russia are unprecedented for a country of its size. This of course means it’s impossible to predict exactly how their impacts will reverberate around the Russian – and global – economy. And we still need to see the exact details of the plan. But on their face they threaten the collapse of the Russian ruble, a run on Russian banks, hyperinflation, a sharp recession and high levels of unemployment in Russia, as well as turmoil in international financial markets."
Feb 26th 2022
EXTRACT: "Putin apparently assumes that China will back him. But while he launched the invasion just weeks after concluding something akin to an alliance agreement with Xi in Beijing, Chinese officials’ reactions have been very distant with calls for “restraint.” Given Putin’s near-total reliance on China for support in challenging the US-led international order, lying to Xi would have no political or strategic advantage. That is what is so worrying: Putin no longer seems capable of the calculations that are supposed to guide a leader’s decision-making. Far from an equal partner, Russia is now on track to become a kind of Chinese vassal state."
Feb 25th 2022
EXTRACTS: "Russia’s ascent to global power in the nineteenth and twentieth centuries resulted in numerous tragedies not only for the neighbors it subjugated and gradually absorbed, but also for its own people. China’s current leaders, in particular, should be mindful of this history, considering that imperial Russia seized more territory from China than from anyone else." ----- "Putin is taking Russia hurtling back toward the nineteenth century, in search of past greatness, whereas China is forging ahead to become the defining superpower of the twenty-first century. While China has achieved unprecedentedly rapid economic and technological modernization, Putin has been pouring Russia’s energy-export revenues into the military, once again cheating the Russian people out of their future."