Expert Commentary

Does the trend toward deflation need another Paul Volcker?

As the financial world mourns a (literal) giant, some people are wondering whether his methods might, ironically, be required again.

Paul Volcker, the ex-Federal Reserve Chairman, died on 8 December at the age of 92. Known as "Tall Paul," standing 6 foot 7 inches, he was most famous for single-mindedly raising interest rates when Fed Chairman, in an effort to crush the rampant price inflation in the late-1970s. Under his watch, and under intense pressure (even death threats), the Fed Funds rate increased from an 11.2% average in 1979 to a peak of 20% in June 1981. After that, interest rates started their generational decline with the Fed Funds target rate now sitting at 1.75%. Many think that the downtrend in interest rates is not over and that negative rates are headed to America, the deflation blob coming via Japan and Europe.

Volcker was a radical but he was conventional in his analysis, thinking that raising interest rates would stamp-out price inflation. At EWI and the Socionomics Institute, our thinking is different. Interest represents the price of money and "demand money" (or short-dated credit) can be heavily influenced by central banks and government. In 1979, prices of goods and services had been inflating for some time. By raising the price of money, Volcker's Fed was merely playing catch-up, as government, the ultimate crowd and always last on a trend, is wont to do. The Fed has also followed, not led, the multi-decade disinflation trend in lowering interest rates. Yet it still insists that by lowering interest rates, price inflation will have a better chance of making a comeback. But what if conventional wisdom, as EWI would advocate, is turned on its head? Enter the Neo-Fisherites.

No, it's not some sort of lunatic-fringe, hard-right-cult of deep sea trawler workers. Instead, Neo-Fisherism refers to the advocates of a policy of raising interest rates in order to re-ignite the growth rate of consumer prices (or price inflation). This paper from the Federal Reserve Bank of St. Louis sets out the detail, but here's a summary.

The celebrated American economist, Irving Fisher, is sadly best known for his ill-timed remark in October 1929 that "stock prices have reached what looks like a permanently high plateau." That's unfortunate because his economic work is interesting. The "Fisher Effect," named after him, refers to the fact that there is a positive relationship between the nominal interest rate and price inflation, as the chart, below, from the article shows. The problem is the interpretation of causation, with conventional wisdom thinking that the movement in price inflation will determine the movement in interest rates. If price inflation ticks up, so should interest rates to choke it off. If price inflation ticks down, so should interest rates in order to re-invigorate it. The Neo-Fisherites argue that the causality is the other way around, and so in order to stimulate price inflation, interest rates should actually be increased. A Volcker-esque increase in Fed Funds to get CPI up? Perhaps that will be the conclusion to this "low-flation" conundrum that haunts central banks. Indeed, maybe the ghosts of Irving Fisher and Paul Volcker are having a good old chuckle about it somewhere.

The scatter chart shows that a positive relationship exists between price inflation (vertical axis) and nominal interest rates (horizontal axis). Higher inflation corresponds with higher interest rates, and vice versa.

191217 - MG