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Pulling Up the Inflation Anchor

Rather than worrying about the prospects of higher long-term expected inflation, the US Federal Reserve is exuding confidence that it can maintain price stability should the need ever arise. It should think again, before the inflation genie has escaped from the bottle.

CAMBRIDGE – Five decades ago, the United States’ biggest macroeconomic problem was high inflation, which averaged more than 6% in the 1970s and rose to as high as 10% by the end of the decade. Then came US Federal Reserve Chair Paul Volcker, who was appointed by President Jimmy Carter in 1979 and reappointed in 1983 by President Ronald Reagan.

In 1981, Volcker famously broke the back of inflation through a policy of high interest rates. By sticking to this policy despite a recession, he convinced financial markets, businesses, and households that the Fed would henceforth do whatever was necessary to ensure low and stable inflation.

Many years later, this strong commitment by a top monetary policymaker may have served as the model for Mario Draghi, when, as European Central Bank president in 2012, he committed to “do whatever it takes” to preserve the euro. No doubt, Draghi’s success in that mission explains why he just became Italy’s prime minister.