It is a sobering fact that the prominence of central banks in this century [i.e. the 20th century] has coincided with a general tendency towards more inflation, not less. If the overriding objective is price stability, we did better with the nineteenth-century gold standard and passive central banks, with currency boards, or even with 'free banking'. The truly unique power of a central bank, after all, is the power to create money, and ultimately the power to create is the power to destroy
The 1979-81 battleground
In August 1979, President Carter appointed Paul Volcker as Chaiman of the Federal Reserve. Annual inflation was over 11%, not dissimilar to now (Exhibit 1), and Carter’s mandate to Volcker was crystal clear – “do whatever you have to do to bring inflation down”. Volcker acted quickly and raised the Fed Funds rate by 50 bps to 11% within days of taking office. At the same time, he sent a stark warning to all US commercial banks to stop lending to “speculative ventures” which he, at the time, defined as real estate and commodity trading.
As it turned out, that did little to curtail inflation and, for the next year and a half, Volcker continued to turn the screw. When he finally stopped in the spring of 1981, the Fed Funds rate had climbed to 20%, an all-time high (Exhibit 2).
Lessons learnt from Volcker
The Volcker era taught us several important lessons: