When the Kennedy and Johnson Administrations started engaging in fiscal activism under the sway of Keynesianism, the Federal Reserve under Chairman William McChesney Martin monetized the resulting deficits.
I do not believe the “Great Inflation” of 1965 – 81 was caused by the monetization of fiscal deficits. The deficits were relatively modest during that period, and the national debt was falling as a share of GDP. Deficits became a much bigger problem beginning in 1982, but that’s exactly when inflation fell to much lower levels. Instead the Great Inflation was probably caused by a mixture of honest policy errors and politics.
Let me throw a third hypothesis into the mix. There was a fair amount of money illusion in financial markets in the 1970s. That is, people looked at high nominal interest rates and thought that this would slow down inflation. In fact, interest rates were not high enough. Relative to financial markets, the Fed was following rather than leading. It was reflecting the views of Wall Street. Finally, in the early 1980s, the “bond market vigilantes” took over, and we had high real interest rates, high unemployment, and a slowdown in inflation. Just to be clear, I am giving the credit for high interest rates to the bond market vigilantes, not to Paul Volcker.
This is the second non-Volcker explanation for the 1980s disinflation that I’ve seen in a week. Mark Faber attributes it to the after-effects of the 1970s capital spending boom in the energy sector and also early growth in cheap Asian exports.
In any case, I just compared the last 60 years of fed funds rates to 10 year Treasury yields as a rough measure of whether Volcker or the bond market was the bigger vigilante. In the 8 quarters from Q3 1979 (Volcker’s term began in August) to Q2 1981, fed funds were 2.5% higher then the 10 year yield, on average. In the 8 quarters from Q4 1979 (Volcker’s first full quarter) to Q3 1981, the average difference was 2.6%. There are no other 8 quarter periods on record showing a gap as high as either of these figures. After Q3 1981, the difference wasn’t especially unusual.
Based on this simple measure, you might conclude that Volcker was leading the vigilantes’ charge in his first two years and set the course for the deep 81-82 recession that did much of the disinflation “work.” After that, both parties kept real rates high all along the curve and made sure inflation didn’t come back as it had after the brief disinflations of the ’70s. And they were helped by the commodity overcapacity and cheap imports mentioned by Faber, although the cheap imports were mostly related at that time to the strong dollar, the benefits and costs of which seem attributable to Volcker.
I understand this is simplistic and doesn’t consider that long yields could have had a stronger economic effect than short rates, but just trying to be fair to Volcker. Maybe there’s other evidence you have in mind that points more toward the bond market as the cause?
Here’s the Faber link if anyone’s interested:
http://www.zerohedge.com/news/2013-11-07/marc-faber-warns-karl-marx-was-right