What Led to the High Interest Rates of the 1980s?

BY busadmin  May 29, 2009 at 12:02 PM EDT

Paul Volcker; via Wikipedia

Question: What were the causes and circumstances that led to the high interest rates in the 80’s? Was it inability to effect a change or inaction in addressing the issue?

Paul Solman: If by “interest rates” you mean the rate set by the Fed — the Fed funds rate — it rose to TWENTY PERCENT in 1980. But no, it was not inaction but just the opposite: a deliberate rise in rates triggered by inflation.

Let’s take a step back for a moment. In general, over the long haul, interest rates are determined by the market. Think of a market interest rate as the sum of three separate factors: waiting, repayment risk, and inflation.

First, waiting — also known as the time value of money. Imagine an inflation-free environment, such as today’s. Which would you take: a thousand dollars today or a thousand dollars, guaranteed, a year from now? Unless you’re a very unusual person, it’s the thousand right now, so you can do something with the money. If you forgo the money, you generally need to be paid something for doing so, for waiting — in recent history, around 2 percent a year.

Second is the risk of not being paid back. This is why folks with low FICO scores have to pay such high rates of interest. This obviously varies enormously. But the U.S. government has generally been thought to pay the “risk-free” rate: 0 percent for risk.

The rest of the interest rate is inflation. If money is losing value and you lend it, you’re going to expect to be reimbursed for the loss.

In the late 1970s, in America, prices were rising fast. In other words, inflation was running rampant, usually thought to be the result of the oil crisis of that era, government overspending, and the self-fulfilling prophecy of higher prices leading to higher wages leading to higher prices. The Fed was resolved to stop inflation. So, Chairman Paul Volcker (who is pictured above) kept raising rates in 1980 and ’81, eventually bringing both the economy and inflation to a standstill.

The Fed showed great “ability to effect change,” to use your phrase, though the cost of killing inflation was a deep recession. You could hardly call the Fed’s behavior “inaction.”