Paul Volcker and the 1980s Rate Shock: What It Cost

Paul Volcker became Chairman of the Federal Reserve, the US central bank (the Fed), on 6 August 1979. US consumer prices were then 11.82% higher than a year earlier, as measured by the Consumer Price Index (CPI), the standard gauge of what households pay.

The Volcker rate shock is the period from 1979 to 1982 when the Fed raised interest rates sharply to bring down inflation. The Fed Funds Rate, the rate banks charge each other for overnight loans, reached a daily high of 22.36%. Two recessions fell in the period, with the Unemployment Rate reaching 10.8%.

In August 1979 the CPI was 11.82% above its level a year earlier. The Fed Funds Rate averaged 10.94% that month. The Unemployment Rate was 6.0%.

Subtracting inflation from the Fed Funds Rate gives the real rate. In August 1979 it was −0.88 percentage points. A negative real rate means a lender is repaid in money that buys less than the money lent. For the link between the two, see Interest Rates and Inflation and What Is a Real Interest Rate?.

The Fed announced three changes on Saturday 6 October 1979. The Board of Governors, the Fed's governing body in Washington, raised the discount rate from 11% to 12%. The discount rate is the rate the Fed charges banks that borrow from it directly.

The Board also made larger banks hold more reserves, the funds banks keep in their accounts at the Fed, against further growth in "managed liabilities". These are certain large deposits and borrowings. The marginal reserve requirement was 8%.

The third change was the Federal Open Market Committee's, the Fed's rate-setting committee, which met that Saturday. It changed the operating procedure. Before it, the Fed kept the Fed Funds Rate within a narrow range.

After it, the Fed gave more weight to the supply of bank reserves. It gave less weight to managing the overnight rate. How the Fed Sets Rates covers the mechanics.

Volcker described the change to Congress on 17 October 1979: "more emphasis will be placed on controlling the provision of reserves to the banking system". He added that the measures should "make abundantly clear our unwillingness to finance a continuing inflationary process".

The daily Fed Funds Rate was 11.61% on 5 October and 13.86% on 9 October.

Chart 1 shows the Fed Funds Rate averaged by month in blue and CPI inflation in orange. The monthly average peaked at 19.10% in June 1981, just above 18.90% in December 1980. The daily rate reached 22.36% on 22 July 1981.

Rates did not rise in a straight line. The monthly average fell from 17.61% in April 1980 to 9.03% in July 1980, then climbed to 18.90% in December 1980. The Fed's own history says credit controls begun by the Carter administration in March 1980 precipitated a sharp recession. It adds that the Fed eased as unemployment rose.

Other rates followed. The Prime Rate, which banks charge their best borrowers, reached 21.5% on 19 December 1980. The average 30-year fixed mortgage rate was 11.08% in the first week of August 1979 and 18.63% in the week of 9 October 1981. The 10-year Treasury yield averaged 15.32% in September 1981.

Chart 2 subtracts CPI inflation from the monthly Fed Funds Rate. The real rate fell to −4.91 percentage points in June 1980. It then rose to 9.55 percentage points in June 1981.

From January 1981 to December 1986 the lowest real rate was 3.45 percentage points, in December 1981. The measure uses inflation after the fact. It does not use any forecast of inflation.

The National Bureau of Economic Research (NBER), the body that dates US recessions, puts one recession from January 1980 to July 1980, which is 6 months. It dates a second from July 1981 to November 1982, which is 16 months. What Is a Recession? explains how those dates are set.

The Unemployment Rate was 6.0% in August 1979, 7.8% in July 1980 and 7.2% in July 1981. It peaked at 10.8% in November and December 1982. It was 8.3% in December 1983 and returned to 6.0% in August 1987, 57 months after it first reached the peak.

CPI inflation peaked at 14.76% in March 1980. It was 8.92% in December 1981, 4.59% in November 1982 and 3.83% in December 1982. November 1982 was the first month below 5%, which is 37 months after the October 1979 change and 32 months after the peak.

Measures differ. The Personal Consumption Expenditures (PCE) Price Index peaked lower, at 11.60% in March 1980.

The Fed's history essay on the October 1979 measures prints 11.6% for that month, which is the PCE figure. This guide uses the CPI throughout. See What Is PCE Inflation? for how the two compare.

The Fed's history essays give some other figures. One says inflation had fallen to 5% by October 1982, where the CPI reading was 5.14%. Another puts the Fed Funds Rate at 20% in late 1980, where the daily rate was 22.0% on 31 December 1980.

A third gives 7.4% for unemployment at the start of the 1981 recession. That is the August 1981 reading. July was 7.2%.

The Federal Reserve's history essay on the Great Inflation, by Michael Bryan, says the origins of that inflation were policies that allowed excessive growth in the money supply. It adds that expectations became standard in macroeconomic models after this period. It also says policy credibility became appreciated as necessary for good macroeconomic results.

Marvin Goodfriend and Robert King reached a different conclusion in a 2005 paper. They argue that the real effects of the disinflation, meaning the lost output and jobs, were mainly due to its imperfect credibility.

They treat the rise in long-term interest rates as a sign of that. For comparison, the 10-year Treasury yield in FRED data rose from 9.03% in August 1979 to 15.32% in September 1981.

Bryan's essay is about where the inflation came from. Goodfriend and King's paper is about why the disinflation cost output and jobs.

The figures show that CPI inflation peaked in March 1980, the monthly Fed Funds Rate peaked in June 1981 and the Unemployment Rate peaked in November and December 1982.

A formula that links the policy rate to inflation and economic slack is covered in What Is the Taylor Rule?. The Fed's inflation goal is covered in Why Does the Fed Target 2% Inflation?.

Under Volcker the Fed Funds Rate reached 22.36%, two recessions occurred and the Unemployment Rate hit 10.8%. CPI inflation fell from 14.76% in March 1980 to 3.83% in December 1982.

On 6 October 1979 the Fed under Volcker raised the discount rate from 11% to 12%. It also changed its operating procedure to give more weight to bank reserves and less to the Fed Funds Rate. That rate then reached a daily high of 22.36% on 22 July 1981. CPI inflation first fell below 5% in November 1982.

The Fed Funds Rate reached a daily high of 22.36% on 22 July 1981. Its monthly average peaked at 19.10% in June 1981. The Prime Rate reached 21.5% on 19 December 1980. The average 30-year mortgage rate reached 18.63% in the week of 9 October 1981.

The Unemployment Rate rose from 6.0% in August 1979 to 10.8% in November and December 1982. The NBER dates one recession from January to July 1980 and a second from July 1981 to November 1982. The rate returned to 6.0% in August 1987.

CPI inflation fell from 14.76% in March 1980 to 3.83% in December 1982. It first dropped below 5% in November 1982, 37 months after the October 1979 change. See Interest Rates and Inflation for how rates and inflation relate.

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