The Volcker Shock was a period of historically high interest rates precipitated by Federal Reserve Chairperson Paul Volcker's decision to raise the central bank's key interest rate, the Fed funds effective rate, during the first three years of his term. Volcker was appointed chairperson of the Fed in August 1979 by President Jimmy Carter, as replacement for William Miller, who Carter had made his treasury secretary. Volcker was one of the most hawkish (supportive of tighter monetary policy to stem inflation) members of the Federal Reserve's committee, and quickly set about changing the course of monetary policy in the U.S. in order to quell inflation. The Volcker Shock is remembered for bringing an end to over a decade of high inflation in the United States, prompting a deep recession and high unemployment, and for spurring on debt defaults among developing countries in Latin America who had borrowed in U.S. dollars.
Monetary tightening and the recessions of the early '80s
Beginning in October 1979, Volcker's Fed tightened monetary policy by raising interest rates. This decision had the effect of depressing demand and slowing down the U.S. economy, as credit became more expensive for households and businesses. The Fed funds rate, the key overnight rate at which banks lend their excess reserves to each other, rose as high as 17.6 percent in early 1980. The rate was allowed to fall back below 10 percent following this first peak, however, due to worries that inflation was not falling fast enough, a second cycle of monetary tightening was embarked upon starting in August of 1980. The rate would reach its all-time peak in June of 1981, at 19.1 percent. The second recession sparked by these hikes was far deeper than the 1980 recession, with unemployment peaking at 10.8 percent in December 1980, the highest level since The Great Depression. This recession would drive inflation to a low point during Volcker's terms of 2.5 percent in August 1983.
The legacy of the Volcker Shock
By the end of Volcker's terms as Fed Chair, inflation was at a manageable rate of around four percent, while unemployment had fallen under six percent, as the economy grew and business confidence returned. While supporters of Volcker's actions point to these numbers as proof of the efficacy of his actions, critics have claimed that there were less harmful ways that inflation could have been brought under control. The recessions of the early 1980s are cited as accelerating deindustrialization in the U.S., as manufacturing jobs lost in 'rust belt' states such as Michigan, Ohio, and Pennsylvania never returned during the years of recovery. The Volcker Shock was also a driving factor behind the Latin American debt crises of the 1980s, as governments in the region defaulted on debts which they had incurred in U.S. dollars. Debates about the validity of using interest rate hikes to get inflation under control have recently re-emerged due to the inflationary pressures facing the U.S. following the Coronavirus pandemic and the Federal Reserve's subsequent decision to embark on a course of monetary tightening.
FAQs
Monetary tightening and the recessions of the early '80s
What effects did the Volcker disinflation have on the economy? ›
In practice, the new approach to monetary policy involved high interest rates (tight money) to slow the economy and fight inflation. Though the policy was successful, the Fed's efforts to lower inflation resulted in a brief recession, from 1981 to 1982, when unemployment peaked at nearly 11 percent.
Why did the Federal Reserve allow interest rates to rise in 1979? ›
Oil prices were to double by early 1980 and triple by early 1981 from November 1978 levels, and by the fall of 1979 the Fed felt that more drastic action was needed to fight inflation. The announcement on October 6, 1979, of the switch to nonborrowed reserve targeting officially opened the inflation-fighting period.
What was Paul Volcker's monetary policy? ›
He raised the discount rate by 0.5 percent shortly after taking office. Volcker also monitored the debt crisis in developing countries and supported the expansion of the International Monetary Fund's reserve fund. During his second term, Volcker made expanding the money supply without increasing inflation his priority.
What was the main cause of inflation in the 1970s? ›
The Great Inflation was blamed on oil prices, currency speculators, greedy businessmen, and avaricious union leaders.
What was the Volcker shock in 1979? ›
The Volcker Shock was a period of historically high interest rates precipitated by Federal Reserve Chairperson Paul Volcker's decision to raise the central bank's key interest rate, the Fed funds effective rate, during the first three years of his term.
What happened to the US economy in 1979? ›
In 1979, Paul Volcker, formerly the president of the Federal Reserve Bank of New York, became chairman of the Federal Reserve Board. When he took office in August, year-over-year inflation was running above 11 percent, and national joblessness was just a shade under 6 percent.
What drove inflation in 1979? ›
Energy and homeownership costs were the major factors driving up the CPI throughout 1979. Gasoline prices rose an average of 35.7 cents a gallon, a 52.2 percent increase. Home heating oil prices climbed almost as much, 33.8 cents a gallon, a 56.5 percent rise for the year.
Who stopped inflation in the 80s? ›
Determined to wring inflation out of the economy, Federal Reserve chairman Paul Volcker slowed the rate of growth of the money supply and raised interest rates. The federal funds rate, which was about 11% in 1979, rose to 20% by June 1981.
What ended 1970s stagflation? ›
The stagflation became more severe in the early 1970s but was suppressed by the price controls and wage freeze imposed by President Nixon starting in August 1971 and through 1972.
Under Federal Reserve Board Chair Paul Volcker, the prime lending rate was raised to above 21% to reduce inflation. Inflationary pressures eased as oil prices and union employment fell, limiting the growth of costs and wages.
What is the Volcker regime? ›
The policy actions of the Volcker Fed in 1979 and 1980, including the celebrated October 1979 announcement of new operating procedures with greater emphasis on money, merely contained inflation in the face of sharply rising inflation expectations evident in bond rates in early 1980.
Do US recession in the 1970s was caused by? ›
Among the causes were the 1973 oil crisis, the deficits of the Vietnam War under President Johnson, and the fall of the Bretton Woods system after the Nixon shock.
What stopped the Great Inflation? ›
Volcker led a series of tight and aggressive monetary policy initiatives—at one point sending the Fed funds rate to 19 percent in 1981—and curbed growth in the money supply. The economy slipped into a recession in 1980, and a deeper one in 1981–82, but inflation eventually dropped to around the 2 percent level in 1983.
Who was brought in to fix inflation in the 1970s? ›
Paul Volcker, then undersecretary of the Treasury for monetary affairs, is pictured at a news conference in Washington, D.C.,. on Feb. 10, 1972. As Federal Reserve Chairman, Volcker sharply raised interest rates to cut down on double-digit inflation.
Why was the economy so good in the 80s? ›
Consumer spending increased in response to the federal tax cut. The stock market climbed as it reflected the optimistic buying spree. Over a five-year period following the start of the recovery, GNP grew at an annual rate of 4.2 percent.
How does disinflation affect the economy? ›
Disinflation refers to a slowing in the rate of inflation, typically when it eases over the short term. Proponents of disinflation argue that it's necessary to prevent the economy from overheating, while opponents say that it can lead to a downturn or cause deflation, as it represents economic contraction.
In what ways is the Volcker disinflation considered a success? ›
The Volcker disinflation was successful in bringing inflation down with contractionary policies; however, these policies resulted in two recessions and a significant increase in unemployment.
What activity does the Volcker rule affect? ›
The Volcker rule generally prohibits banking entities from engaging in proprietary trading or investing in or sponsoring hedge funds or private equity funds.
What are the effects of deflation on an economy? ›
Not only does deflation signal a stagnating economy, it can lead to high unemployment, unaffordable debt repayment, and dismal outcomes for businesses.
