Lesson of the Day: The Math of Inflation

From The New York Times, I’m Michael Barbaro. This is The Daily.

Later today the U.S. government is expected to deploy its most powerful tool for fighting inflation, knowing full well that it will weaken the economy. I spoke with my colleague, Jeanna Smialek, about why that is and the painful lesson from a previous era that has convinced American policymakers that this is the right path.

It’s Wednesday, March 16th.

Jeanna, The Federal Reserve— in just a few hours, we think— is going to raise interest rates in order to lower inflation in the American economy. Can you just help us understand the mechanics of that? How does that work?

So as everyone knows, prices are rising really quickly right now on cars, on meat, on couches. And there are a few reasons for that. The government spent a lot of money at the start of the pandemic and throughout last year to sort of blunt the impact of the coronavirus and its effect on workers.

Right, there were stimulus checks, for example.

Exactly. And that spending fueled really strong demand. Unfortunately, that strong demand collided with supply chains that were all messed up. And so there were too many dollars chasing too few goods and inflation really jumped up.

Today, even though the government is spending less, the checks have stopped. The labor market is really strong. And that’s helping to sustain this pretty robust demand and it’s keeping inflation rising. And so we have this real problem where prices have been going up a lot. And now the Fed is getting worried that inflation is going to get stuck at this higher rate that they do not want.

And so the idea is if you raise interest rates, if you make it more expensive to borrow money to buy a car or to borrow money to buy a house, then fewer people will do those things. There will be less demand and supply will have a chance to catch up, which will allow price increases to slow down a little bit.

Right. When the Fed raises the interest rate, it essentially pours a tall glass of cold water on the economy. It deliberately tries to slow down spending.

Right. You slow things down to bring inflation under control.

Which has always struck me as kind of strange because what you’re describing is a process of our own government hurting the economy in order to eventually help the economy.

Right. And so this is the way that central bankers control inflation everywhere. But here in the United States, there’s a good reason why central bankers tend to be especially attuned to periods where it seems like inflation might hop out of control. And that is because there’s a historical example where they did not react quickly enough to inflation, where inflation became really painful. And it’s this period that kind of haunts the nightmares of central bankers.

So tell us the story of that time period that haunts economists. When did it start?

So the story starts in the mid to late 1960s, really during Lyndon B. Johnson’s presidency, when there is just this huge amount of government spending happening.

Johnson famously tried to tackle poverty in this ambitious program called the Great Society.

And while that’s happening, the country still engaged in the war in Vietnam.

And that’s also increasing government spending by billions and billions of dollars.

So there’s a lot of government money pouring into the economy and inflation just starts to gradually ratchet up year after year. And many economists think that the government spending from the 1960s helped to kick off that process. But then inflation keeps on rising.

By the 1970’s, this spiraling inflation had another important effect on Americans.

People began to change the way they thought about their money, the way they thought about inflation.

So Americans began to feel like their money wasn’t going to go as far because prices were so high and they began to ask for higher wages to cover their rising expenses. And you saw that as companies had to pay more, they started charging more to cover their costs. And we ended up in a situation where prices and wages were in this upward spiral and they were kind of chasing each other.

And so that proceeds through the 1970s. And we’re really seeing these very, very rapid price increases on a year-over-year basis.

And it’s worth pausing just a moment to understand what high inflation like that actually feels like. Groceries are a good example because they bounced around a lot but at times hit double digit inflation in the 1970s. Given those rates, if you had a $100 grocery order in 1970, it would have cost about $170 in 1978 to buy the same exact things.

Wow.

And during the 1970s, both in the early 70s and then in ‘79, there were oil embargoes.

And so when those happened, they sort of supercharged this already very high inflation and pushed the cost of gas up quite a lot. And so between gas and food and all of these sort of day-to-day necessities, you just saw a wide variety of consumer goods starting to become more expensive. It really became sort of this economy-wide problem where prices for everything were going up and it wasn’t clear how it was going to end.

And how did Americans feel about all this inflation?

Americans did not feel good about all of this inflation, especially in the 1970s when it started really hitting oil prices because they are just so visible. You see them up on a price board and it just was such a big part of people’s everyday lives. So people were angry about it. It is just everywhere in the culture. You see it in old magazine articles. You see it in comic strips.

Comedians are making jokes about it.

It shows up in All in the Family, the sitcom.

And so this just became a sort of everyday kitchen table issue here in America.

So what did the U.S. government do to address this?

Not as much as you might think. And the reason for that is elected officials are not especially good at cooling down the economy enough to wrestle inflation under control because obviously if you want to win reelection, you do not want to slow down your economy and possibly tip it into a recession. And so politicians talk about it a lot, but they really don’t sort of roll out any super aggressive policies that are enough to constrain prices.

And then at the same time, you have central bankers who for various reasons over the years really just aren’t willing to raise interest rates enough and sort of hurt the economy enough to bring prices under control. And so basically there’s just no sort of concerted government response that is effective at bringing down inflation in these years. The can keeps getting kicked down the road and we end up with very high inflation that is sort of embedded in the fabric of society and feeding on itself.

Right. And no one’s willing to do anything about it.

Or at least not enough. And that was basically the case for a decade until 1979. President Jimmy Carter is at the helm. He’s struggling to salvage public confidence in his administration and the economy is just a disaster. So he starts to shuffle cabinet members around, which opens up the top position at the Federal Reserve. And he calls up this candidate named Paul Volcker.

Volcker’s already a senior official within the Federal Reserve System and there’s a few things he’s known for. First, he’s very tall, 6 foot 7. He’s also frugal. He likes drugstore cigars. He wears badly fitted suits and he continued driving a car with a broken seat around after he broke it. And he kind of applies all of that frugality to his economic policy. Up until this point, he’s been pretty frustrated with the Fed’s half-hearted attempts to curb inflation and he wants the Fed to take a harder line approach.

So Volcker gets to his Oval Office interview and basically tells Jimmy Carter that if he gets the job, he’s going to push interest rates higher. And the clear implication there is that he’s going to support a policy that hurts the economy while Carter is still in office and that he’s not going to continue to allow inflation to just run out of control the way it’s been doing. And so he goes home from this interview absolutely positive that he’s not going to get the job given what he’s just told the president.

Right because he just told the president, I’m going to make you unpopular.

Exactly, exactly. And so he’s flabbergasted when the next morning, his phone rings very early in the morning— he’s still in bed— and it’s Jimmy Carter. And Carter tells him, hey, you got the job.

And suddenly Paul Volcker finds himself chairman of the Federal Reserve.

We’ll be right back.

So, Jeanna, once Paul Volcker is the head of the Federal Reserve, what does he do?

So Paul Volcker basically makes good on what he has promised President Jimmy Carter, which is he wages a war on inflation. And we really see that start in earnest in October 1979.

There’s the super dramatic scene. On a Saturday night, Paul Volcker decides to hold a press conference, which at the time is very rare. The Fed doesn’t do a lot of these.

And on a Saturday night.

And on a Saturday night, right? And not just any Saturday night, on a Saturday night when the pope is in town.

Woah.

And so the Washington press corps is very devoted to following the pope around. And Paul Volcker and his communications staff call up the press and say, no, come on down to the Eccles building. And Volcker’s spokesperson actually has to convince some of the press to show up to this, including the CBS cameraman who basically says, I have limited resources and I’m going to the pope. And the press person says, long after the pope is gone, you’re going to remember what happens tonight.

So a lot of drama, a lot of pomp and circumstance. The press comes down. And Volcker basically tells the press that the Fed is going to change how it’s setting monetary policy, that they are going to shake up their whole approach and the whole goal here is really just to vanquish inflation, to bring it down once and for all, to really get a handle on this. This is basically a declaration that things are going to change.

Right. And how does he do it?

Volcker was really committed to the idea that you had to crush inflation completely to get America out of this self-perpetuating cycle. And so he gets aggressive. He took an interest rate that was already at 10 percent in 1979 and basically pushed it up to 17.6 percent within like a year. By early 1981, his policies pushed rates up to about 19 percent.

Wow.

And soon it’s close to 20 percent. And that’s just this incredibly high interest rate and has ratcheted up there in an incredibly short amount of time.

And just for a moment, explain what it means for the interest rate to be almost 20 percent in the United States because it’s kind of hard to fathom.

So remember interest rates very directly translate into how much it costs to buy a house, to borrow to buy a car, or to borrow with a credit card. So let’s just take a house, for example. If you buy a $100,000 house and you’re going to pay it off in 30 years without any interest on that loan— which isn’t realistic, but just for the example— your payments are going to be about $300 a month.

Of course, if you’re paying a mortgage rate and the interest rate on your loan is 20 percent, so around that 1981 level, your payments would be closer to $1,700 a month. So that could obviously be prohibitively expensive, especially if you’re dragging it out over time.

It costs so much to borrow at this stage that you’re paying thousands, maybe tens of thousands more than you previously would have just to buy a car, a house, a boat, whatever it is that you want to borrow money to buy.

And so people just stop doing it. They just stop spending money on those things. And as that happens, America sinks into recession and that recession is really painful.

How bad? Describe it.

Terrible.

Unemployment rose above 10 percent.

The human impact of what Paul Volcker is doing with policy is just palpable at this point. People are out of work. People are seeing their wage growth absolutely crushed. You’ve got car lots full of cars that just can’t sell. You’ve got homebuilders who just can’t sell houses.

So what you see happening is just this outpouring of anger because people know that interest rates are the thing inflicting so much damage and so much pain throughout the economy. They know that this is Fed policy driving this terrible recession.

And so people mail two-by-fours— homebuilders mail two-by-fours to the Federal Reserve in protest of the houses they can’t sell. The car dealers mail car keys in protest of the cars they can’t sell. And you see at one point, farmers actually bring tractors and circle the Fed in Washington out of protest of these very high interest rates and the intense pain that is being felt just throughout the entire economy at this stage.

But, Jeanna, it almost sounds like the cure was worse than the disease. While inflation was bad, people were not losing their jobs or getting priced out of loans for homes and cars the way they were once interest rates soared, right?

Right. So that is actually a school of thought that it was worse to raise interest rates than it would have been to let the inflation go. But most economists will tell you that if inflation would have gone unchecked, it might have gotten worse. And the uncertainty around how much money was going to be worth in the future could have been really harmful for the economy and just for Americans as a whole.

So how do you plan or save if you don’t know what $1 is going to buy in a year? And so it just wouldn’t have been a solid foundation to use to build up the rest of the economy. And Volcker was very, very aware of how painful this all was. And we know now that he really agonized over what he was doing to the economy during this period. In his memoir, he describes this patch of carpet in his office that he literally wore out from pacing it so much.

And he heard a lot of feedback. People publicly blamed him for just about everything.

But he didn’t stand down. There’s this moment that’s pretty well known in the nerdy circles that I run in— when he was prodded on a show called The MacNeil/Lehrer Report.

And Volcker was encouraging the country to basically keep this bigger picture in mind.

I think overall he is definitely grappling with the pain he’s causing the economy. But he is sort of remaining dedicated to this broader goal and this broader plan which is to bring inflation down even if it costs a lot to do that.

Right. And, of course, the biggest question of all is, does this work?

It is very painful, but it does work. We eventually go from 14.6 percent inflation in March 1980 to closer to 1 percent inflation by 1986. And so you just see this really rapid, really extreme deceleration in price increases. And inflation is under control in a way that it hasn’t been in decades.

As that happens, you get a lot of really positive knock on effects throughout the rest of the economy. And so consumers start to have much more stable outlooks. Businesses also start to feel like they can plan ahead and that they don’t have to worry about prices just going crazy. And as those two things happen, we see it really affecting behavior.

Businesses start to invest again.

Consumers, as interest rates come down alongside inflation, are able to buy houses again. Cars are selling again.

Really by the late 1980s and early 1990s, we’re having a really strong, solid, steady growth economy.

Then in the 1990s—

You get a productivity boom as personal computers come online. And really just we’ve set the stage for these several decades of very strong, very stable growth. And that is sort of the legacy of this Volcker era.

So it’s not a stretch to say that Volcker did as he promised, slay the dragon of inflation with this strategy of higher interest rates and showed that hurting the economy in the short-term really does improve the economy in the long-term?

I think that has become sort of the economic consensus in the time since. Yes, I think people very much attribute the good outcome to Paul Volcker. So this does great things for Paul Volcker’s reputation in the intervening years. And one person who grew up in the inflationary era and who is a real big admirer of Paul Volcker is Jay Powell, the current Fed chair. And Jay Powell has talked publicly about his deep admiration for Paul Volcker.

When Volcker’s autobiography came out a couple of years ago—

Powell talked about how he thinks that he and his colleagues should be thinking about this example as something that they want to emulate.

And so really a long track record of just really looking up to this former Fed chair and his long ago predecessor.

And if you are somebody like Jay Powell and you study this era closely, as it sounds like Powell did, what is the big lesson of the 1970s and Paul Volcker that Powell would carry into a moment like this?

I think that the big overarching lesson is that you don’t want to let inflation carry on for so long that it becomes sort of a major part of how people think about the world because once that happens, it is so painful to cure. Powell, like many economists in this era, has really studied the pain that Volcker had to put the economy through. And nobody wants to see a repeat of that. It was a really miserable era.

And so I think the lesson is you get out ahead of this early. You take care of it as soon as it starts to become a problem. Basically, you don’t be the Fed in the 1960s and 1970s and just let this drag on year after year and kick the can down the road. You try and take care of it right away.

Right. Which is why later today Powell is going to raise the interest rate just a little, which will inflict a little bit of pain, you’re saying, so that he never has to do what Volcker did, which is raise it again and again and again and inflict a tremendous amount of pain on the American worker and the American economy.

Exactly. Powell is going to nudge the rate up a little bit at this meeting. And he’s probably going to sort of send a signal that the Fed is going to continue raising interest rates steadily throughout the year. But the goal here is to maybe eventually raise interest rates up to perhaps 3 percent. So nothing like the 20 percent that Volcker was touching by the early 1980s.

So instead of a tall glass of cold water being poured on the economy, it’s kind of like a spritz.

Right. And the sort of hope and dream here is to sort of cool off the economy, to pull down inflation, to get things under control, but to do that quickly and to do that in a gentle way so that you don’t have to inflict the tremendous amount of pain that Paul Volcker did in the 1970s and 1980s.

Well, Jeanna, thank you very much. This has been very enlightening.

Thank you for having me.

We’ll be right back.

Here’s what else you need to know today.

In a dramatic show of solidarity with Ukraine, three European heads of state— the prime ministers of the Czech Republic, Poland, and Slovenia— traveled to Kyiv on Tuesday, despite heavy Russian shelling across the city.

During a briefing, Ukrainian President Volodymyr Zelensky thanked the prime ministers for taking the risk of visiting him in a war zone.

In Washington, the White House said that President Biden himself would travel to Europe next week to show his support for both Ukraine and NATO. Meanwhile, Russian forces said they had taken control of the entire region of Kherson in Ukraine’s South, where local officials said that Russian troops have been rounding up activists who opposed Russia’s presence.

Finally, Russia imposed sanctions against 13 American officials, including President Biden, Secretary of State Antony Blinken, and Defense Secretary Lloyd Austin in retaliation for U.S. sanctions against Russian officials.

Today’s episode was produced by Rikki Novetsky, Diana Nguyen and Mooj Zadie. It was edited by Liz O. Baylen, contains original music by Marion Lozano, Elisheba Ittoop, and Dan Powell and was engineered by Chris Wood. Our theme music is by Jim Brunberg and Ben Landsverk of Wonderly.

That’s it for The Daily. I’m Michael Barbaro. See you tomorrow.