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
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. This demonstrates the importance of the Fed's independence from the political process.
What did the Federal Reserve do in late 1979 to address the economic problems facing the nation? ›
O It continued its policy of targeting growth rates for the money supply and keeping the FFR within a narrow range. It switched to direct management of monetary base and allowed the FFR to freely fluctuate.
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.
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 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.
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 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.
What mistake did the Federal Reserve make to cause the Great Depression to be worse? ›
The Federal Reserve failed in both parts of its mission. It did not use monetary policy to prevent deflation and the collapse of output and employment. And the Fed did not adequately perform its function as lender of last resort.
What brought on the worst economic slump in the early 1980s? ›
Lasting from July 1981 to November 1982, this economic downturn was triggered by tight monetary policy in an effort to fight mounting inflation. Prior to the 2007-09 recession, the 1981-82 recession was the worst economic downturn in the United States since the Great Depression.
What was the biggest recession in history? ›
The Financial Crisis of 2007–08
This sparked the Great Recession, the most-severe financial crisis since the Great Depression, and it wreaked havoc in financial markets around the world.
The financial crash and global recession of 2008 was "the worst economic disaster since the Great Depression of 1929", according to The Balance. The crash was triggered primarily by the collapse of the U.S. Housing Market, according to Investopedia.
What was the highest inflation rate in US history? ›
The 10 Highest Annual Inflation Rates in U.S. History
| Year | Annual Rate of Inflation |
|---|
| 1 | 1917 | 17.84% |
| 2 | 1918 | 17.28% |
| 3 | 1920 | 15.63% |
| 4 | 1919 | 15.24% |
6 more rowsHigh budget deficits, lower interest rates, the oil embargo, and the collapse of managed currency rates contributed to stagflation. Under Federal Reserve Board Chair Paul Volcker, the prime lending rate was raised to above 21% to reduce inflation.
Why was unemployment so high in 1982? ›
The economy entered 1982 in a severe recession and labor market conditions deteriorated throughout the year. -The unemployment rate, already high by historical standards at the onset of the recession in mid-1981, reached 10.8 percent at the end of 1982, higher than at any time in post-World War II history.
What effects did the Volcker disinflation have on the economy? ›
During this period, the U.S. experienced two recessions generally attributed to disinflationary monetary policy, the 1981–1982 recession exhibiting the largest cumulative business cycle decline of employment and output in the post-World War II period.
When did the Volcker Rule become effective? ›
On December 10, 2013, the Volcker Rule regulations were approved by all five of the necessary financial regulatory agencies. It was set to go into effect April 1, 2014. The final rule had a longer compliance period and fewer metrics than earlier proposals.
What happened in 1979 economics? ›
1979-83 Double-dip recession: Iranian Revolution in 1979 disrupts oil markets and leads to another quadrupling of the nominal oil price. Volcker's Fed applies strongly contractionary monetary policy starting in late 1979 to deal with high inflation. Recession in 1979-80 is followed by even larger one in 1982-83.
How did Volcker respond to the economy in the late 70s early 80s? ›
The Federal Reserve board led by Volcker raised the federal funds rate, which had averaged 11.2% in 1979, to a peak of 20% in June 1981. The prime rate rose to 21.5% in 1981 as well, which helped lead to the 1980–1982 recession, in which the national unemployment rate rose to over 10%.
What is the Volcker disinflation? ›
The Volcker disinflation was a period of monetary policy tightening implemented by Federal Reserve Chairman Paul Volcker in the early 1980s. The goal of the policy was to reduce high inflation rates that had been plaguing the United States economy for over a decade.
