Is Paul Volcker Right? Not This Time

05/20/2008 08:47 am ET | Updated May 25, 2011

It is hard not to admire Paul Volcker. He is that odd thing in contemporary America, a truly dedicated public servant to whom, it seems, making money in the private sector was always secondary. He is a straight shooter. He tells it like he sees it.

As Federal Reserve chairman, appointed by Jimmy Carter in 1979, he eventually broke the back of inflation by imposing a harsh monetary policy of very high interest rates. For this, he is canonized today.

Now, Volcker is saying in public speeches that we should be wary of inflation again, drawing parallels to the high-inflation 1970s that was so painful for the nation. Rising food and fuel prices sound awfully familiar. In other words, he is telling the central bank not to be too loose with monetary policy, that maybe they let rates go too low and it is time to stop the generosity.

But, in fact, we are not nearly in the same historical position as we were in then. Even by the early 1970s, when Richard Nixon was president, consumer price inflation had reached six percent, not on the basis of food and fuel price hikes, but the general rise in the price level. Already, business was getting accustomed to raising prices and workers to asking for higher wages. Many wage contracts were formally indexed to inflation. The recession of 1969-70 did not knock the inflation rate down very far.

After Nixon imposed a wage-price freeze in August 1971, which by the way Volcker helped design as part of Nixon's Treasury Department -- he had has always been an inflation hawk -- the paranoid president stepped on the fiscal gas and got his friend, the relatively new chairman of the Federal Reserve, Arthur Burns, to step on the monetary gas. They pumped up the economy so hard in 1972 so Nixon could win re-election, there was no turning inflation back without pain.

At the same time, crops around the world went bad, then in 1973 and 1974 OPEC quadrupled the oil price, and then Nixon ended controls, which had almost as much impact on inflation as OPEC had.

Inflation became deeply embedded. As inflation rose, business prices and wages rose to keep up, sending inflation still higher. People bought now when prices increased, rather than deferring purchases, because they thought inflation would go only higher. By the end of the decade, the CPI hit an annual rate of 13 percent.

Can we get to that point again? Sure. But we are not nearly there, not remotely there. Underlying inflation is not rising now, food and fuel prices are. Inflation at current levels, which are still below 4 percent, is almost certainly temporary. Why? Because the economy is weak, not strong as under the Nixon stimulus. Because food and fuel are not likely to keep rising at current rates, even if they stay at current prices. Because there is a reasonable chance food and fuel prices may actually come down rapidly once a speculative bubbles pops.

Because inflation is not embedded in our consumer and business decisions, in our wage setting, and in our interest rates. No one thinks the Fed won't step on the brakes far sooner this time then in the 1970s.

And, finally, given the depth of the credit crisis and the ongoing fall in house prices, there is a far bigger risk of worldwide economic cataclysm than there was in the 1970s.

So the Fed is doing the right thing now. Don't overreact to inflation now. Avoid the larger pain. If inflation keeps rising, which is unlikely, then apply the brakes mildly but persistently. It is highly likely this Ben Bernanke Fed will do that. If the economy turns the corner and starts up again, expect the Fed to raise short-term rates sooner rather than later.