Managing a New Policy Framework: Paul Volcker, the St. Louis Fed, and the 1979-82 War on Inflation

Abstract

In October 1979, Federal Reserve Chairman Paul Volcker persuaded his Federal Open Market Com­­mittee (FOMC) colleagues to adopt a new policy framework that (i) accepted responsibility for controlling inflation and (ii) implemented new operating procedures to control the growth of monetary aggregates in an effort to restore price stability. These moves were strongly supported by monetarist-­­oriented economists, including the leadership and staff of the Federal Reserve Bank of St. Louis. The next three years saw inflation peak and then fall sharply but also two recessions and considerable volatility in interest rates and money supply growth rates. This article reviews the episode through the lens of speeches and FOMC meeting statements of Volcker and St. Louis Fed president Lawrence Roos and articles by Roos's staff. The FOMC adopted monetarist principles to establish the Fed's anti-inflation credibility, but Volcker was willing to accept deviations of money growth from the FOMC's targets, unlike Roos, who viewed the targets as sacrosanct. The FOMC abandoned monetary aggregates in October 1982 but preserved the Fed's commitment to price stability. The episode illustrates how Volcker used a change in operating procedures to alter policy fundamentally and later adapt the procedures to changed circumstances without abandoning the foundational features of the policy.

Introduction

Paul A. Volcker was confirmed by the United States Senate as the twelfth Chairman of the Board of Governors of the Federal Reserve System on August 6, 1979. Prior to this appointment, Volcker was serving as the president of the Federal Reserve Bank of New York. Although his public service encompassed years before and after his term at the Fed, many believe that Volcker's crowning achievement was leading the Federal Open Market Committee's (FOMC's) successful fight against the Great Inflation. Volcker died on December 8, 2019, at the age of 92. Upon learning of his passing, Federal Reserve Chair Jerome Powell issued a statement noting that Volcker "exemplified the highest ideals—integrity, courage, and a commitment to do what was best for all Americans. His contributions to the nation left a lasting legacy." 

Volcker was appointed Fed Chairman after a decade of high and rising inflation that was undermining economic stability. Determined to slay inflation once and for all, Volcker pushed the FOMC in October 1979 to adopt new operating procedures to control the growth of monetary aggregates, which he argued was important for bringing down the rate of inflation. The FOMC's acceptance of Volcker's recommendation was widely regarded as a victory for "monetarist" principles espoused by Milton Friedman, Karl Brunner, Allan Meltzer, and many other economists. The Fed's "monetarist experiment" ended in October 1982 when the FOMC largely abandoned the targeting of monetary aggregates, but by that point inflation had already peaked and was trending downward. 

The "Volcker disinflation" has been widely studied and discussed, with most of the focus being on the Fed's adoption of new operating procedures in October 1979 and subsequent actions to bring inflation under control. By contrast, this article examines the episode from the perspective of the leadership and economists of the Federal Reserve Bank of St. Louis. The St. Louis Fed had long been known as the "maverick" Bank within the System because its presidents and staff advocated monetarist policy prescriptions and frequently clashed, both privately and publicly, with the Board of Governors, its staff, and a majority of FOMC members. Volcker would later note in an interview that "the thorn in everyone's side for a couple of decades was the St. Louis Reserve Bank. It went off on its own tack very noisily." 

The FOMC's apparent acceptance of monetarism in October 1979 was widely seen as a victory for the St. Louis Fed. In the words of Anatol (Ted) Balbach, who led the Bank's Research Department at the time, "[T]he greatest achievement of St. Louis, is precisely…that Volcker finally bit the bullet and controlled the money supply." Lawrence Roos, president of the Federal Reserve Bank of St. Louis at the time, heartily approved of the change in operating procedures and publicly praised Volcker's leadership. Roos had been appointed to lead the St. Louis Fed in 1976 upon the resignation of Darryl Francis. Supported by the St. Louis Fed's long-time research director Homer Jones and his staff economists, Francis had vigorously advocated monetarist policy prescriptions. Although not an economist himself, Roos adopted the monetarist viewpoint of his predecessor and staff in his public remarks and statements at FOMC meetings. At first, Roos counseled patience with the new regime even when economic activity faltered. Over time, however, he and his staff grew increasingly critical as the Fed was either unable or unwilling to hit consistently its announced targets for money growth. Whereas Roos's speeches and remarks at FOMC meetings reflected an unwavering monetarist position, Volcker was a pragmatist who was unwilling to pursue strict monetary targeting when the relationship between money growth and nominal spending appeared to break down and the economy faltered. Drawing from the public remarks and statements at FOMC meetings of Volcker and Roos and articles in the Federal Reserve Bank of St. Louis Review, we document the growing divisions between Volcker's policies and the strict monetarist position of the St. Louis Fed, from the adoption of the new operating procedures in October 1979 to their abandonment in October 1982. 

This article is primarily retrospective. One of our motivations for writing the article is to honor one of the major players in a key episode of the Fed's history. Volcker was a forceful leader who acted on his conviction that a regime change was necessary to bring inflation under control. Many of the obituaries and commentary after his death approvingly cited Volker's commitment to restoring price stability and the Fed's credibility. Volcker's policies were controversial at the time, however, and arguably contributed to a severe "double-dip" recession in 1980-81. However, in hindsight at least, they have been widely hailed as appropriate and necessary to win the fight against inflation. Besides offering a new perspective on this important episode in U.S. monetary history, the article illustrates some of the challenges a central bank can face when it adopts a new policy framework and how the Volcker Fed navigated those challenges. We conclude by considering the lasting influence of the "monetarist experiment" on Federal Reserve monetary policy and in particular how Volcker adapted the Fed's operating framework in a way that preserved the fundamental focus of policy on price stability and set the stage for the Great Moderation era that followed. Such episodes can provide insights for policymakers contemplating significant changes in their policy frameworks, such as the FOMC framework review announced in late 2018.