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.

Exhibit 1: US consumer price inflation since 1960 (year-on year in %)

Source: US Bureau of Labor Statistics

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).

Exhibit 2: US Federal Funds rate since 1954

Source: macrotrends.net

Lessons learnt from Volcker

The Volcker era taught us several important lessons: