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From the archiveCase study · Oct 1979–19826 min read

The Volcker shock: rates near 20% to break inflation

On 6 October 1979 the Fed stopped steering the funds rate and began targeting bank reserves. Rates swung wildly and approached 20%, bond yields hit records, and CPI inflation fell from 14.8% to about 4% in under three years.

RatesFXMacroJuniorTrader desk · 8 sources

  • On Saturday 6 October 1979 the Fed switched from steering the funds rate to targeting bank reserves. The rate, about 11.5% before the switch, later approached 20%.

  • Rates became volatile and the 10-year yield hit a record of about 15.8% in 1981. Some of the world’s highest real rates pulled money into the dollar until its 1985 peak.

  • fell from 14.8% in March 1980 to about 4% by late 1982, at the cost of two recessions. The lesson still holds: credibility is bought by showing you will bear the pain.

The trader’s angle

It is the template every central bank reaches for when inflation gets out of hand: change the reaction function, accept the pain, and watch markets reprice everything from overnight money to the dollar.

Fed funds rate, monthly average peak

19.1%

upJune 1981

From about 11.5% before the switch. In October 1979 the band of rates the Fed would tolerate widened from 50bp to 400bp.

CPI inflation, peak

14.8%

downMar 1980; about 4% by end-1982

Inflation kept climbing for five months after the October 1979 switch: policy works with a lag.

10-year Treasury yield, record

about 15.8%

up30 Sep 1981

Long-dated bonds demanded a huge premium until investors believed the Fed would hold its nerve. The 1981 peak began a decline that ran until 2020.

Trade-weighted dollar

+77%

upmid-1980 low to Feb 1985

The Cleveland Fed’s measure. High US real interest rates pulled in foreign money until the Plaza Accord of September 1985.

A central bank can fix the price of overnight money or the quantity of it, but not both. Usually it sets the price, its , and supplies whatever reserves banks want at that rate. That keeps the rate steady from day to day.

The alternative is to fix the quantity of reserves and let the rate float. Then every change in banks’ demand for reserves shows up in the price, and the rate can jump by whole percentage points rather than a few .

In October 1979 the Fed chose quantity. It no longer decided where the funds rate went; the market did, and the Fed signalled it would tolerate whatever rate it took to slow money growth.

What happened

By the autumn of 1979 US inflation had been climbing for more than a decade and the dollar was weak. The money supply (M1) was growing at an annual rate above 9%, far beyond the Fed’s target of 1.5–4.5%. On Saturday 6 October the Fed’s policy committee held an unscheduled meeting, and that evening Fed chair Paul Volcker announced the results at a rare press conference.

The package had three parts. The rate the Fed charges banks at its rose a point, to 12%. Banks faced an extra 8% reserve requirement on increases in managed liabilities such as large certificates of deposit and eurodollar borrowing, which made it dearer for them to fund new lending.

And, most important, the Fed changed how it ran policy. It would now target the quantity of bank reserves and let the federal funds rate move with the market. In September the committee had held the funds rate in a 50bp band around 11.5%. In October it widened the band it would tolerate to 400bp, eight times as wide.

Why it happened

Fed research traces the Great Inflation to policies that let the money supply grow too fast, and to officials who wrongly believed much of the inflation lay outside the central bank’s control. Rate rises in small steps had not stopped prices climbing, and rising inflation had become built into what households, firms and investors expected.

Targeting reserves changed the mechanics. Under the old system the Fed set the price of overnight money and supplied whatever reserves banks wanted at that price. Under the new one it fixed the quantity: if money growth ran hot, banks competing for scarce reserves would push the funds rate up, however high it had to go.

The aim was credibility: to convince everyone that this time the Fed would not back down. Volcker himself was willing to accept money growth straying from its targets along the way. The commitment mattered more than the mechanism.

How it ripples through markets

How a change of method broke the Great Inflation

  1. 1

    Inflation gets built in

    By 1979 money growth runs far above target, the dollar is weak and everyone expects prices to keep rising.

  2. 2

    The Fed targets reserves

    upFed funds rate

    6 Oct 1979: the Fed fixes the quantity of reserves and leaves the funds rate to the market, so banks competing for scarce reserves push it up; the discount rate goes up a point to 12%.

  3. 3

    Short rates soar and swing

    upFed funds rate

    With the quantity fixed, every shift in banks’ demand for reserves shows up in the price: the funds rate averages 17.6% in April 1980, drops in the 1980 recession, then approaches 20% in 1980–81.

  4. 4

    Bonds demand a premium

    up10y Treasury yield

    Investors demand extra yield against inflation until they believe the Fed won’t back down, so long yields climb: the 10-year hits about 15.8% in September 1981.

  5. 5

    Money floods into the dollar

    upUS dollar

    Some of the world’s highest real rates pull in capital; the trade-weighted dollar rises 77% from mid-1980 to February 1985.

  6. 6

    Recession, then disinflation

    downUS inflation

    High rates choke borrowing and spending: unemployment nears 11% in late 1982, and inflation falls to about 4%.

Why it mattered for traders

Short-term rates stopped being a policy choice and became a market price, and interest-rate volatility jumped. The funds rate averaged 17.6% in April 1980, then fell sharply as a recession took hold, worsened by credit controls imposed in March 1980. It rose again to approach 20% in late 1980 and early 1981, and its monthly average peaked at 19.1% in June 1981.

Long-dated demanded a large until investors believed the Fed would hold its nerve: the 10-year hit a record of about 15.8% on 30 September 1981. Very tight money, alongside loose , gave the US some of the highest real interest rates, rates after inflation, in the world, and capital poured in. The trade-weighted dollar rose 77% from its mid-1980 low to its February 1985 peak, by the Cleveland Fed’s measure, until the Plaza Accord of September 1985 set out to bring it down.

The lesson for traders: when a central bank changes its , old ranges stop meaning anything.

What happened next

Inflation broke. CPI inflation peaked at 14.8% in March 1980 and was down to about 4% by the end of 1982. The price was steep: a recession in 1980 and another from July 1981 to November 1982, with unemployment reaching nearly 11% late in 1982, its highest since the Second World War.

In October 1982 the Fed largely dropped its money targets, as financial innovation had made M1 an unreliable guide, and went back to steering the funds rate. It kept the credibility it had earned. The 1981 peak in the 10-year yield marked the start of a decline that ran, with interruptions, for almost four decades, to a record closing low of about 0.5% in August 2020.

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Sources

An original summary written from the sources above. Figures are rounded; follow the links for the full record.

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