Paul Volcker

Labeled as “monetary pragmatist”, took over in Aug 1975. Since beginning, he leaned toward tight
money policies and high interest rates to retard inflation. His approach was to follow a course of
monetary policy that will permit only moderate growth in money and credit. Stagflation -- the lethal
combination of high unemployment and high inflation -- reflected a change in consumers’ behavior. The
“buy now, pay later” philosophy adopted by those with jobs overwhelmed the spending restraint of the
unemployed, resulting in higher prices. Economists had to rework their thinking to take account of
Milton Friedman’s warning that gains in employment would disappear once inflationary expectations
caught up with reality.

Volcker understood the power of expectations. At his very first FOMC meeting on Aug. 19, 1975, he had
warned the optimists on the committee not to be encouraged by the projections “for reduced inflation
emanating from some econometric models,” which he said “did not take adequate account of the
important factor of expectations.”

The Fed's job was to control how much money was in the economy. And Volcker thought it had simply
printed too much. So shortly after he took office, he made a big announcement. The Fed was going to
tightly restrict the amount of money in the economy. The result - not what he had hoped. The thing he
was trying to fix, inflation, got worse. It went from 12 percent up to 14 percent. And meanwhile, the
economy started to crash. When you restrict the amount of money in the economy, it gets harder for
people and businesses to get loans. So now we had inflation and a recession. Millions of people lost
their jobs.

In the textbooks, once you stop printing so much money inflation should go away. But it was taking a
long time. One reason it was taking so long - people did not believe inflation would go down. Part of the
problem was in our heads. If people believe there's going to be inflation, then they go to their bosses
and they say, you got to give me a raise to keep up with inflation. Employers say, OK, and to pay for
those higher wages they raise prices for whatever they sell. There you go - inflation. It's a self-fulfilling
prophecy. Volcker stuck to his guns, limited the amount of money in the economy. And by the end of
1981, inflation finally began to drop - 9 percent, then 6 percent, 4 percent.

Volcker fought 10% annual inflation rates with contractionary monetary policy. He courageously
doubled the Fed funds rate from 10.25% to 20% in March 1980. He briefly lowered it in June, but
inflation returned. Volcker then raised the rate back to 20% in December and kept it above 16% until
May 1981. That extreme and prolonged interest rate rise was called the Volcker Shock. It did end
inflation. Unfortunately, it also created the 1981 recession.

Why the Volcker Shock Worked

Volcker knew he must take dramatic and consistent action to get everyone to believe that he could
tame inflation. President Nixon had created inflation by ending the gold standard in 1973. The dollar's
value plummeted on the foreign exchange markets. That made import prices higher, creating inflation.
Nixon tried to stop it with wage-price controls in 1971. That restricted business activity, slowed growth,
and created stagflation.

The Fed Chair, Alfred Hayes tried to fight inflation and recession at the same time. He raised and
lowered interest rates in an inconsistent fashion. That stop-go monetary policy confused consumers and
businesses. In 1972, Congress ended wage-price controls. Worried companies just raised prices to stay
ahead of future high-interest rates. Consumers kept buying more before prices rose even more. The Fed
lost credibility, and inflation rose to double digits.

Thanks to Volcker, central bankers realize the importance of managing inflation expectations. As long
as people thought prices would keep going higher, they had the incentive to spend now. The
added demand only drove inflation higher. Consumers stopped spending when they realized Volcker
would end inflation. Businesses stopped raising prices for the same reason.

The India Story

Raghuram Rajan in September 2013 had his own “Paul Volcker moment”. (In 1978, in his first Federal
Open Market Committee (FOMC) meeting as chairman of the Federal Reserve, Paul Volcker “defined his
moment” saying: “Economic policy has a kind of crisis of credibility. As a result, dramatic action to
combat inflation would not receive public support without more of a crisis atmosphere”.) CPI as a
benchmark for the rate corridor has created a framework for policymakers both monetary and fiscal
side. It has also allowed for a harmony in terms of aligning policy frameworks on supply side reforms, to
support the environment that keeps inflation low.

Modi in a pre-election speech stated that the government has no business to be in business, reminiscent
of Ronald Reagan. Modi believes less government, more governance. That's India's Reagan 1980
moment. Since then most of the government actions have been towards addressing clarity on improving
templates that facilitate smooth governance, with more transparency, prudence and fairness. It is
focusing on core governance leaving the business to the businessman.

EPFO taking on the risk of investing in equities as well as credit over a period of time, and SIPs almost
reaching the 10 million mark. This is India's 401(k) moment. The velocity of these flows are set to
accelerate with increased thrust on enveloping the parallel economy, incentivizing financial savings and
enforced financialization of assets.

Median Age and GDP growth has a strong correlation. Increasing %ge of baby boomers in US economy,
better growth and higher proportion of financial savings complemented the phase of wealth creation in
USA. The policy focused on taming inflation, falling median age of working population, sustained flows
to financial markets gave the U.S. a long period of non-inflationary, continued expansion where
investors made money across asset classes. It also gave birth to several new markets – the junk bond
market which did not exist between 1929 and 1977, when Bear Stearns and Mike Milken built the junk
bond market; a large REIT market; a muni market which is $3-3.5 trillion; securitization and asset backed
and mortgage backed securities. We feel the recent success of INVITs would further accelerate
financialization of physical assets.
https://www.crisilresearch.com/Pdf/CRISIL_Assocham_Pension_Report_July_2015.pdf
http://www.fimmda.org/uploads/general/HR-Khan-Speech.pdf
https://www.crisil.com/bond-market/pdf/Are-Stars-Aligning-for-Growth-of-Corporate-Bond-Market-in-
India.pdf

India’s journey from a $2 trillion economy to $6 or $8 or $10 trillion, cannot be complete given the kind
of infrastructure we have in terms of the capital market. Innovation can happen given the strength that
we have built in the whole ecosystem. There have been enough steps to create a clarity in terms of
regulatory environment in terms of SEBi, IRDA,etc. Further there are reforms like the bankruptcy code,
and more transparent information code to facilitate right credit to corporate/ institutional sector which
can help create healthier debt/bond markets. The episodes that we have seen in credit is very similar to
incidents in the U.S. Be it in REITs, muni market, asset backed securities, mortgage backed securities -
these events are very necessary for a healthy growth of the market. Healthy infusion of technology,
defined roadmap and digitally literate nation over the next 5-years would only hasten this
transformation.