Five decades ago, the United States’ biggest macroeconomic problem was high inflation, which averaged more than 6% in the 1970s and rose to as high as 10% by the end of the decade. Then came US Federal Reserve Chair Paul Volcker, who was appointed by President Jimmy Carter in 1979 and reappointed in 1983 by President Ronald Reagan.
In 1981, Volcker famously broke the back of inflation through a policy of high interest rates. By sticking to this policy despite a recession, he convinced financial markets, businesses, and households that the Fed would henceforth do whatever was necessary to ensure low and stable inflation.
Many years later, this strong commitment by a top monetary policymaker may have served as the model for Mario Draghi, when, as European Central Bank president in 2012, he committed to “do whatever it takes” to preserve the euro. No doubt, Draghi’s success in that mission explains why he just became Italy’s prime minister.
The key to Volcker’s legacy is the anchoring of long-term inflation expectations at a low value, around 2% per year since the 1990s. This anchor translated into actual price stability, with inflation remaining at a low average rate of about 2%.
Having established confidence about long-term expected inflation, the Fed soon found that it had a lot of short-term policy leeway: it could adjust short-term nominal interest rates and quantities of monetary aggregates without jeopardizing its long-run credibility. For example, it kept short-term nominal rates close to zero for extended periods and dramatically expanded its balance sheet, all while maintaining the key anchor of low long-term expected inflation.
Unfortunately, this reputational capital that Volcker bequeathed is now being threatened by reckless monetary and fiscal policies. The Fed’s balance sheet nowadays seems to observe no limits, and fiscal deficits as a share of GDP are running at unprecedented peacetime levels.
The Fed now exudes confidence—or rather, overconfidence—that nothing it does will affect long-term inflation expectations. Indeed, if anything, it wants inflation to rise from around 1.5% per year toward its target of near 2%. But rather than wringing its hands over below-target inflation today, the Fed should be worrying more about the potential for a sharp rise in long-term expected inflation.
Consider the current US inflation figures. Before the COVID-19 recession, from early 2010 to early 2020, the inflation rate for the consumer price index (CPI) averaged 1.7% per year, and the average rate calculated for the Fed’s favorite price-level measure—the deflator for personal consumer expenditure—was similar, at 1.5% per year.