What really drives inflation
In a recently available speech in Jackson Hole, Fed Chair Jay Powell organized the Fed’s new monetary policy framework. Under this framework, the Fed allows inflation to perform above its 2% target to be able to boost employment carrying out a downturn. The brand new framework marks a departure from the perceived wisdom of the 1970s’ Great Inflation. Under this perceived wisdom, the Fed must respond aggressively to rising inflation or risk losing its credibility and letting inflation spiral uncontrollable. New research on the fantastic Inflation challenges this perceived wisdom and will be offering a fresh explanation for what really drives inflation. Rather than Fed credibility, this explanation puts the economic climate and how it transmits monetary policy front and centre. In doing this, it reconciles the 1970s with the existing environment and a foundation for understanding why the Fed’s new framework is unlikely to trigger runaway inflation.
The Fed’s new framework overturns earlier thinking. As Powell explained, “THE FANTASTIC Inflation demanded a clear concentrate on restoring the credibility of the FOMC’s commitment to price stability. Chair Paul Volcker brought that focus to bear” (Powell 2020). In the 1970s, the narrative goes, the Fed didn’t raise interest levels fast enough to push away rising inflation. This resulted in a lack of credibility, which allowed inflation to spiral uncontrollable. Volcker broke the spiral by raising interest levels to unseen levels and keeping them there until Fed credibility was restored. Inflation came down and stayed down, launching the fantastic Moderation. This narrative was formalised in a famous paper by Clarida et al. (2000).
The most obvious question arises: won’t the Fed’s new framework squander its hard-won credibility and trigger runaway inflation? The Fed is currently explicitly promising to let inflation run above target unchecked. Beneath the perceived wisdom of the fantastic Inflation, this could result in an inflation spiral. With record federal deficits and an enormous Fed balance sheet, shouldn’t we worry? These concerns were echoed in two recent VoxEU columns by Olivier Blanchard (2020) and Charles Goodhart (2020).
In a fresh paper (Drechsler et al. 2020), you can expect a different explanation for the fantastic Inflation – why it began and just why it ended – that delivers an answer to the question. The explanation is easy, yet up to now completely overlooked. It centres on a significant law referred to as Regulation Q. Regulation Q placed hard ceilings on the interest levels banks were permitted to pay their depositors. This meant that regardless of how high the Fed raised interest levels, it made no difference to many people. The transmission of monetary policy through the economic climate was broken. This is exactly what made inflation escape control. And it had been the repeal of Regulation Q towards the end of the 1970s that brought inflation to heel.
Figure 1 plots the Regulation Q ceiling rate on the most frequent kind of deposits, savings accounts (other deposits had only slightly different ceilings). In addition, it plots inflation, the true deposit rate, which subtracts inflation, and the Fed funds rate (the primary instrument of monetary policy). 1
As the figure shows, Regulation Q first became binding in 1965, when the Fed funds rate rose above the deposit rate ceiling. That is precisely when inflation first found, which explains why historians date it as the beginning of the fantastic Inflation. 2 After that, depositors always received a below-market rate. In 1969, the ceiling rate was 4% as the Fed funds rate was 8%. Inflation was 6%, hence depositors received a genuine rate of -2%, down from +2% in 1964. Such a big decline in the true rate creates a robust incentive to spend instead of save. The increased desire to invest pushes up prices and creates more inflation. Given the ceiling, higher inflation lowers the true deposit rate further, that leads to more spending and more inflation – an inflation spiral. By 1973, the true deposit rate had declined to -6%; and by 1979: to -8%! It’s no wonder that inflation had accelerated to 14%.
Regulation Q had another important effect on the economy. The rates on deposits became so unappealing that banks and S&Ls, which depended almost entirely on deposits, became starved for funds. 3 Regulation Q had created a market meltdown. That is illustrated in Figure 2, which plots the true growth rate of deposits alongside inflation and the Fed funds rate. Also shown is real GDP growth, which captures real fiscal conditions.
The figure shows a striking pattern: whenever interest levels rose and the deposit rate ceiling became tighter, banks suffered massive contractions of deposits. The first contraction was in 1965 when Regulation Q first became binding. 4 Another contraction occurred in 1969, when deposit growth swung from +8% to -4%. Then in 1973 it swung from +13% to -5%, and in 1979: from +11% to -8%. The credit crunches thus spiralled with the inflation rate.
As we saw in 2008, credit crunches are devastating for the economy. It really is no real surprise then that in the figure real GDP growth is highly correlated with deposit growth. Whenever inflation rose and deposits fell, GDP plummeted. This happened in 1965, 1969, 1973, and 1979. The pattern is equivalent to with deposits and inflation: each contraction was worse compared to the one before. Regulation Q thus naturally explains the other characteristic feature of the time: the mix of rising inflation and falling GDP, a phenomenon referred to as ‘stagflation’.
What ended the stagflation? While banks and especially S&Ls had initially supported Regulation Q believing it raised their profits and stabilised their funding costs, by the finish of the 1970s Regulation Q had few friends. One reason was the chance of competition from Money Market Funds, that have been just getting started. 5 Congress responded by repealing Regulation Q in a number of steps. The first was the introduction of Money Market Certificates (deregulated time deposits with denominations over $10,000) in late 1978. These were accompanied by Small Saver Certificates (no minimum denomination) in late 1979. Within a year or two, a vast amount of funds: $462 billion, a proportion of GDP add up to $3.5 trillion today, poured into these new deregulated deposit products. Regulation Q was effectively over.
Figure 3 shows the dramatic impact of the repeal of Regulation Q. Within a year of their introduction, deregulated deposits had raised the deposit rate by 7% above the old ceiling. The true deposit rate jumped from -8% in 1979 to 0% in 1980. As the incentive to invest receded, inflation started to drop. It actually did so slightly before Volcker’s credibility-restoring rate hike, which came by the end of 1980. With inflation dropping, the true deposit rate rose even higher: to +7% in 1981. The spiral was moving in reverse. By 1982, inflation was below 4%. Deposit rates closely tracked the Fed funds rate. Monetary policy transmission was restored, setting the stage for the fantastic Moderation.
What exactly are the lessons of the for today and for the Fed’s new framework? The foremost is that since Regulation Q is no more on the books, there is absolutely no reason to anticipate a rerun of the 1970s. The next lesson is that the complete policy rule of the Fed (the so-called Taylor coefficient) and its own effect on Fed credibility aren’t that important. Chair Powell is then to tolerate somewhat higher inflation in trade for more jobs.
The 3rd lesson is that whatever the Fed’s policy, a well-functioning economic climate must be around to transmit it. As Regulation Q shows, this will not just mean avoiding bank failures. Although we no more have an interest rate ceiling to worry about, we do have an interest rate floor: the zero lower bound. And just as the ceiling prevented rates from increasing, which gave us high inflation, the ground prevents rates from heading down, giving us persistently low inflation. Viewed this way, the brand new normal isn’t so different in the end.
Burger, A E (1969), "A historical analysis of the market meltdown of 1966", Federal Reserve Bank of St. Louis Review, September 1969.
Clarida, R, J Galí and M Gertler (2000), "Monetary policy rules and macroeconomic stability: evidence plus some theory", The Quarterly Journal of Economics 115(1): 147-180.
Meltzer, A (2005), "Origins of the fantastic Inflation", Federal Reserve Bank of St. Louis Review, March (2005): 145-176.
Powell, J H (2020), "New Economic Challenges and the Fed’s Monetary Policy Review", at "Navigating the Decade Ahead: Implications for Monetary Policy", an economic policy symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, August 27-28.
1 Inflation and the Fed funds rate are annualized over the next year at every time.
2 The original uptick in inflation is often related to rising deficits from the Vietnam War. This and the oil shocks of 1973 and 1979 could be regarded as sparks that got the fantastic Inflation going (Meltzer 20050. Yet they are one-off events rather than large enough to describe the sustained acceleration of inflation through the entire period (the inflation spiral). For this reason the typical explanation in the literature may be the lack of Fed credibility and its own restoration under Volcker. Volcker specifically would not have already been needed if the fantastic Inflation was because of such transitory shocks.
3 S&Ls or Savings and Loan Institutions, were thrifts that raised deposits to create mortgage loans. They truly became insolvent when Regulation Q was lifted and their funding costs skyrocketed. This resulted in the famous S&L crisis.
4 Interestingly, it had been at the moment that the word “credit crunch’’ was coined (Burger 1969).
5 Regulation Q thus arguably gave rise to the shadow banking industry. In addition, it gave rise to the Eurodollar market, which helped large investors find ways around Regulation Q. Even Freddie Mac was made in 1970 to alleviate the market meltdown in mortgages due to Regulation Q.