What really drives inflation
The Federal Reserve’s new framework overturns earlier thinking. As Chair Janet Powell explained, “[t]he Great Inflation demanded a clear focus 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, it is argued that the Federal Reserve failed to raise interest rates fast enough to stave off rising inflation. This led to a loss of credibility, which allowed inflation to spiral out of control. Volcker broke the spiral by raising interest rates to unseen levels and then keeping them there until the Federal Reserve’s credibility was restored. Inflation came down and stayed down, launching the ‘Great Moderation’ (this narrative was formalised in a famous paper by Clarida et al. 2000).
An obvious question arises: won’t the Federal Reserve’s new framework squander its hard-won credibility and trigger runaway inflation? The Federal Reserve is now explicitly promising to let inflation run above its target unchecked. Under the perceived wisdom of the ‘Great Inflation’, this could lead to an inflation spiral. With record federal deficits and a massive Federal Reserve balance sheet, shouldn’t we worry? (Blanchard 2020, Goodhart 2020).
In a new paper (Drechsler et al. 2020), we offer a different explanation for the Great Inflation (why it began and why it ended) that provides an answer to this question. The explanation is simple, yet so far completely overlooked. It centres on an important law known as ‘Regulation Q’. Regulation Q placed hard ceilings on the interest rates banks were allowed to pay their depositors. This meant that no matter how high the Federal Reserve raised interest rates, there was no clear difference for the majority of people. The transmission of monetary policy through the financial system was broken. This is what made inflation run out of control. It was the repeal of Regulation Q at the end of the 1970s that brought inflation to back under heel.
Figure 1 plots the Regulation Q ceiling rate on the most common type of deposits, savings accounts (other deposits had only slightly different ceilings). It also plots inflation, the real deposit rate (which subtracts inflation), and the Federal Reserve funds rate (the main instrument of monetary policy).1
As the figure shows, Regulation Q first became binding in 1965, when the Federal Reserve funds rate rose above the deposit rate ceiling. This is precisely when inflation first picked up, which is why historians date it as the start of the Great Inflation.2 From then on, depositors always received a ‘below-market’ rate. In 1969, the ceiling rate was 4%, while the Federal Reserve funds rate was 8%. Inflation was 6%, which meant that depositors received a real rate of -2% (down from +2% in 1964). Such a large decline in the real rate creates a powerful incentive to spend rather than to save, and the increased desire to spend pushes up prices, creating more inflation. Given the ceiling, higher inflation lowers the real deposit rate further, which leads to more spending and more inflation—an ‘inflation spiral’. By 1973, the real deposit rate had declined to -6%, and by 1979 this had dropped down further to -8%. It is not surprising that inflation had accelerated to 14% at this stage.
Regulation Q had another important impact on the economy. The rates on deposits became so unappealing that banks (and savings and loan associations), which depended almost entirely on deposits, became starved for funds.3 Regulation Q had created a credit crunch. This is illustrated in Figure 2, which plots the real growth rate of deposits alongside inflation and the Federal Reserve funds rate. Also shown is real GDP growth, which captures real economic conditions over the same interval.
The figure shows a striking pattern: whenever interest rates 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 A second contraction took place in 1969, when deposit growth swung from +8% to -4%. Then, in 1973 it swung from +13% to -5%, and in 1979 it moved from +11% to -8%. The credit crunches therefore appear to spiral with the inflation rate.
As seen in 2008, credit crunches are devastating for the economy. It is no 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 the same as with deposits and inflation: each contraction was worse than the one before. Regulation Q naturally explains the other characteristic feature of the period: the combination of rising inflation and falling GDP, a phenomenon known as ‘stagflation’.
What caused the end of stagflation? While banks as well as especially savings and loans associations had initially supported Regulation Q (believing it raised their profits and stabilised their funding costs), by the end of the 1970s Regulation Q had few friends. One reason was the prospect of competition from Money Market Funds, which were just starting out.5 Congress responded by repealing Regulation Q in several steps. The first was the introduction of ‘Money Market Certificates’ (deregulated time deposits with denominations over $10,000) in late 1978. They were followed by ‘Small Saver Certificates’ (no minimum denomination) in late 1979. Within a couple of years, a vast amount of funds ($462 billion, a proportion of GDP equal 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 real deposit rate jumped from -8% in 1979 to 0% in 1980. As the incentive to spend receded, inflation began to drop. It should be noted that it actually did so slightly before Volcker’s credibility-restoring rate hike, which came at the end of 1980. With inflation dropping, the real deposit rate rose even higher: to +7% in 1981. The spiral was going in reverse. By 1982, inflation was below 4%. Deposit rates closely tracked the Federal Reserve funds rate. Monetary policy transmission was restored, setting the stage for the Great Moderation.
What are the lessons for today in terms of the Federal Reserve’s new framework? The first lesson is that since Regulation Q is no longer on the books, there is no reason to expect a re-run of the 1970s. The second lesson is that the precise policy rule of the Federal Reserve (the so-called ‘Taylor coefficient’) and its impact on Federal Reserve credibility are not that important. Chair Powell is therefore right to tolerate somewhat higher inflation in exchange for more jobs.
The third lesson is that whatever the Federal Reserve’s policy, a well-functioning financial system has to be around to transmit it. As Regulation Q shows, this does not just mean avoiding bank failures. Although we no longer have a rate ceiling to worry about, we do have a rate floor: the zero-lower bound. Just as the ceiling prevented rates from going up (causing high inflation), the floor prevents rates from going down, creating persistently low inflation. Viewed in this way, ‘the new normal’ is not so different after all.
Blanchard, O (2020), “Is there deflation or inflation in our future?“, VoxEU.org, 24 April.
Burger, A E (1969), “A historical analysis of the credit crunch 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 and some theory”, The Quarterly Journal of Economics 115(1): 147-180.
Drechsler, I, A Savov and P Schnabl (2020), “The Financial Origins of the Rise and Fall of American Inflation“.
Goodhart, C A E (2020), “Inflation after the pandemic: Theory and practice“, VoxEU.org, 13 June.
Meltzer, A (2005), “Origins of the Great 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 following year at every point in time.
2 The initial uptick in inflation is often attributed to rising deficits from the Vietnam War. This and the oil shocks of 1973 and 1979 can be thought of as sparks that got the Great Inflation going (Meltzer 20050. Yet they are one-off events and not large enough to explain the sustained acceleration of inflation throughout the period (the inflation spiral). This is why the standard explanation in the literature is the loss of Fed credibility and its restoration under Volcker. Volcker in particular would not have been needed if the Great Inflation was due to such transitory shocks.
3 S&Ls or Savings and Loan Institutions, were thrifts that raised deposits to make mortgage loans. They became insolvent when Regulation Q was lifted and their funding costs skyrocketed. This led to the famous S&L crisis.
4 Interestingly, it was at this time that the term “credit crunch’’ was coined (Burger 1969).
5 Regulation Q thus arguably gave rise to the shadow banking industry. It also gave rise to the Eurodollar market, which helped large investors find ways around Regulation Q. Even Freddie Mac was created in 1970 to relieve the credit crunch in mortgages caused by Regulation Q.