05.November.2021 – US

Will inflation bring forth hyperinflation and drastic increase in interest rate, like Paul Volcker’s era?

 

The inflation rate has been soaring up since the aftermath of COVID-19. Most of price indicators, including oil, gas, agricultural products and even wages are on the rapid rise.

 

The surge in price has been largely caused by a lack of supply and increased demand post COVID-19 world. The question is, will this rising inflation continue or stop?

 

Jerome Powell, the chairman of the FED, once said that he expects this inflation to be short lived, and that the inflation will slow down once things get back to normal.

 

However, some people started to question if that is really the case. What happens if inflation spirals out of control, as some investors fear?

 

We can draw a parallel lesson from Paul Volcker, who was the chairman of the FED from 1979 to 1987.

 

From 1973 to 1974 and 1978 to 1979, as indicated in the red boxes below, there were energy crises caused by a drop in oil production in the wake of the Iranian Revolution.

 

The oil crisis led to a huge spike in inflation rate, as indicated by blue line in the image below. As the inflation rate spiked well above 10%, Paul Volcker decided to raise the federal funds rate to put a cap on what seemed to be likely to become hyperinflation.

Oil shock inflation and interest rate

Source: Fred.stlouisfed.org

 

With drastic increase in interest rate, inflation was tamed and remained well below 5% in the subsequent years.

 

The cause in recent spike in inflation rate is different from that in the 1970s; however, it can be seen from the past that skyrocketing inflation rate can only be reined in by raising interest rate well beyond the inflation rate.

 

Currently, inflation rate is well above 2-3% range, while the federal funds rate still remains in 0%.

 

Will inflation rate spiral out just like in the past, or is it a temporary spike that will have to be reined in by raising interest rate?

 

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