The Volcker Tightening Cycle: Explaining the 1982 Course Reversal

Abstract

This article studies the factors that led former Federal Reserve Chairman Paul Volcker to stop and then reverse course in the most famous monetary tightening cycle in U.S. history. I explain how the Fed began cutting its policy rate target, thus ending the tightening cycle, in July of 1982. Although the Fed had gained some ground in its fight against inflation, in mid-1982, inflation was running above 7 percent, well above the 2 percent inflation rate that the U.S. enjoyed before the Great Inflation. Beyond the Federal Open Market Committee’s (FOMC) partial success at taming inflation, I describe how economic pain and financial market stress were two practical and related considerations in the summer of 1982 that likely contributed to the monetary policy pivot. Finally, I discuss the political pressure facing the FOMC at that time.

Introduction

Between the middle of the 1960s and the early 1980s, the U.S. experienced a period of large and volatile inflation known as the Great Inflation. The Fed’s overly easy monetary policy largely drove this sustained inflation. Meltzer identified the main causes as “analytic errors,” stemming from the widespread adherence to the simple Keynesian model with its downward-sloping Phillips curve, political choices, and decision-making as well as “the entrenched belief that inflation would continue” (Meltzer, 2005, p. 145).

In large part, the analytic errors were due to the popularity of Keynesian economics. This view took the empirical regularity of the Phillips curve—the negative relationship between the observed inflation rate and the unemployment rate in the U.S. and U.K. over various historical periods—as a “menu” for policymakers. Policymakers could choose how much inflation the public could withstand in order to achieve low unemployment. A citizenry experiencing a high unemployment rate could have its central bank reduce unemployment by raising the inflation rate through easier monetary policy.

There was an abrupt change in policy with Paul Volcker’s confirmation as Federal Reserve Chair in August 1979. Volcker changed Fed operating procedures to target the money stock as well as entered into a monetary tightening cycle. Much has been written on the Great Inflation, the change in operating procedures, and the Volcker disinflation (particularly its start). See, for example, the Federal Reserve Bank of St. Louis Review’s 2005 Proceedings of a Special Conference “Reflections on Monetary Policy 25 Years After October 1979.”

Much less has been written on the Fed’s decision to switch to an easing policy once inflation began to decline. In this article, I address a narrow topic: What drove Volcker and the FOMC to end the tightening cycle that they began in 1979? There is no doubt that Volcker and the FOMC dramatically brought down inflation from an elevated level by tightening monetary policy. In the summer of 1982, they reversed course by beginning to lower their “tolerance ranges” for the federal funds rate. This reversal occurred despite the fact that inflation remained at 7 percent at the time, with internal Fed forecasts from the time anticipating about a 5 percent inflation rate for 1983. By contrast, in the decade or so before the Great Inflation, average inflation was around 2 to 2.5 percent.