Is Volcker Shock Coming Back?
Updated: Sep 25, 2022
After another Fed meeting and another historically high rate hike, it’s clear that the Fed is committed to fighting inflation, but are we risking the Volcker Shock all over again?
FOMC No. of Participants Reporting Weighted upside RIsks to Core PCE inflation
The Fed's preferred gauge of inflation, the personal consumption expenditure or PCE price index, rose for the fifth straight month and reached a 30-year high of 4.2% on August 26. Now we have the highest FOMC No. of participants reporting weighted upside risks to core PCE inflation.
Market Expectations for Fed hikes at the next 4 FOMC meetings
75 bps hike to 3.75-4.00%
50 bps hike to 4.25-4.50%
25 bps hike to 4.50-4.75%
To bring inflation under control, the Federal Reserve is committed to tightening monetary policy, and they will do so by slowing the economy. Each quarter they also present their estimates for how the economy will likely develop over the following several years, and these projections extend to 2025. According to their forecasts, inflation will not slightly exceed their objective of 2% until 2025.
However, inflation continues to grow despite the Fed's delay tactics and policy lag, and there is still no sign of when or how the Fed will reduce its monetary actions. But even if the Fed progressively lessens its support for the economy and markets by purchasing market assets such as bonds with newly produced currency, the central bank is aware that it will not be sufficient. The Fed will inevitably respond, and when they do, it will be in ways other than just ceasing to add more paper money to the fire.
Back in August, Powell was asked at a recent Town Hall meeting what book he advises reading, which provided us with a clue. He gave a lengthy, laudatory speech praising former Fed Chair Paul Volcker, promoting Volcker's book Keeping at It and describing him as "history's most outstanding public servant in economics."
In the late 1970s Volcker came to office while damaging double-digit inflation was reaching as high as 14%, and he planned to aggressively increase interest rates and reduce the money supply. His strategies resulted in short-term interest rates as high as 19%, which halted inflation over the course of three years. Volcker defeated inflation, allowing our economy to recover. The only issue is the immense and unprecedented historical suffering unleashed on our economy and markets for around three years.
This time became so dire that it was dubbed "The Volcker Shock." According to Powell at the Town Hall, Volcker "did what was best for the country" in the long run: Volcker defeated inflation and paved the way for "a long and very excellent time for the development of the US economy."
Today, forty years after Volcker's time, inflation and inflation expectations are on the rise, so what can we anticipate if Powell responds to inflation like Volcker? As soon as Volcker became chairman of the Federal Reserve in 1979, he said that he would begin limiting the increase of our money supply to combat inflation. This is just the opposite of what Powell has done up to this point. Volcker accomplished this by controlling the rise of bank reserves, which may be manipulated by the Fed. As money in banks became scarcer and demand for money exceeded supply, banks increased interest rates, so reducing the amount of liquid assets accessible to the economy. The "Volcker Shock" is essentially a "no-money shock." Most of us have felt the effects of having no money at least once in our lives, and if you have, you understand what financial hell is like. This occurred during the tenure of Volcker.
How may employment numbers be impacted if Volcker's strategies were replicated in today's economy?
During that time, businesses and employers faced a double whammy. The high interest rates gave savers returns of almost 10 percent on their savings accounts, prompting those who had money to save it, so reducing consumer spending. Coupled with the higher cost of borrowing required to keep a business operating, this will result in tens of thousands of enterprises and employers failing simultaneously. The unemployment rate nearly doubled as a result. The industrial belt was the hardest-hit region, with citizens in several cities competing for seats in homeless shelters.
Chart of the unemployment rate from May 1979 to September 1982
How Equity Market was Impacted by Volcker Shock
In the decade after Nixon's departure of the Gold Standard in 1971, the Dow Jones (adjusted for inflation) fell by 50 percent. Enter Volcker's interest rate hikes in October 1979, and throughout the implementation of Volcker's remedy over the course of three years, the market fell a further 30%, concluding one of the worst 12 years in history for stock market portfolios by destroying all stock market values. This crisis precipitated a retirement crisis, as retirees dependent on their stock market portfolios were forced to return to the workforce, which, as previously said, was generally unavailable.
Inflation Adjusted Chart of the Dow-Jones Industrial Average from 1972 to 1982
Does the evidence point to a modern-day repeat of Volcker’s Shock?
With month-to-month inflation increases and Powell's admiration for Volcker, current conditions are somewhat different. But does the Fed need to significantly increase interest rates like Volcker to combat inflation today?
Currently, probably not as substantially. However, today's significantly lower interest rates will wreak havoc on our economy because our debt level is significantly bigger than it was in 1979. Now, even a historically typical interest rate of 5–6% would make interest payments on our debt extremely difficult for the regulators to manage. In fact, the current state of our economy is so precarious that even in the face of mounting inflation, the Federal Reserve has no plans to cease creating money, let alone raise interest rates.
Thus, with its money printing and zero interest rate program for more than a decade, if left unchecked, would result in hyperinflation and the loss of the dollar's reserve currency status. The only option may be to undergo a painful "Chemo" treatment in the form of continued rate hikes.