Kevin Warsh’s Mission: Reviving the Era of Monetary Restraint

There is a widespread perception that inflation in the United States is closely connected to the war in Iran. This means that every time some good news comes out of the Gulf, politicians, the media and certain economic voices celebrate price decreases, including the price that they think drives all others: oil. When news from the Gulf turns bad, negative sentiment gains traction.

Of course, what happens—or doesn’t happen—in the Gulf impacts the supply and price of oil and clearly has an influence on other prices. But that’s not what’s keeping the inflation rate unacceptably high. That problem goes back decades and has deeper causes than Middle East turmoil and the price of oil.

Which is why it was refreshing and reassuring to hear the new chairman of the Federal Reserve, Kevin Warsh, say unequivocally: “The members of our committee have no tolerance for persistently elevated inflation.”

This is the key problem: Inflation has become “persistently elevated,” meaning it has remained above the Fed’s 2 percent target for almost a decade. The target itself is highly questionable, since 2 percent inflation for an almost nine-year period—the amount of time during which it has been above the target—would reduce the buying power of a dollar by just under 18 percent. Is that a desirable target in and of itself?

That aside, the truth is that, if we consider the trimmed-mean Consumer Price Index—which excludes the most extreme price changes—since 2017, total inflation has amounted to almost twice as much: around 36 percent.

The problem started at the end of the 1980s, under Alan Greenspan. Against the philosophy he had espoused for decades, Greenspan started to systematically print money and manipulate interest rates when he assumed the Fed helm. This had been done many times before, but Greenspan inaugurated an inflationary era that would last 40 years. It began as a panicked response to the stock market crash of Oct. 19, 1987, known as Black Monday, and as is often the case with public policy, saw no end.

Was inflation necessary to create economic growth? No. Under William McChesney Martin, who presided over the Federal Reserve in the 1950s and 1960s, there was monetary restraint. As a result, inflation averaged just 1.4 percent per year between 1952 and 1966, while U.S. gross domestic product, discounting inflation, grew a solid average rate of 4 percent a year.

Compare that to the last two decades, when money has been printed like there is no tomorrow, which is why the Fed’s balance sheet has grown to a whopping $6.7 trillion and was even considerably higher not too long ago.

Economic growth during this more recent period has been considerably lower, on average, than during the McChesney Martin period of monetary restraint. Using trimmed-mean Consumer Price Index, annual inflation in the second quarter of this year was 2.8 percent and has averaged 3.5 percent over the last nine years.

The underlying inflation problem goes well beyond U.S. Middle East policy. In fact, the annualized inflation rate in the most recent quarter of this year was very close to the rate during the final quarter of the Biden administration, when oil was flowing freely through the Strait of Hormuz.

The big question is whether Warsh will want to follow through on his commitment—which would involve continuing to shrink the bloated balance sheet he inherited and keeping interest rates above the level many politicians, including the top one, would ideally want in an election year. Inherent in the slow but steady approach is the risk of triggering a recession, something that would not be Warsh’s fault, to be fair, but the fault of the inflationary policies of previous decades.

Are Warsh and other members of the Federal Open Market Committee prepared to risk a recession in order to undo four decades of inflationary folly, setting the ground for more robust economic growth and increased household purchasing power?

It’s been done before. Against wind and tide, Paul Volcker did it in the 1980s. Yes, his draconian measures helped cause the recession of the early 1980s, but they also ushered in a long and sustained period of solid growth for the rest of the decade.

The tragedy is that Volcker’s successors, toward the end of that decade, decided to turn back the clock.