Paul Volcker’s Legacy, 30 Year Anniversary of Floating Rates

Today is the 30th anniversary of the Fed rate system as we know it. After their October 6, 1979 FOMC meeting, the Fed announced a drastic change to monetary policy. Up until that time the money supply fluctuated with business cycles and rates were relatively fixed—the Fed Funds Rate was only allowed to float about 50 basis points. The Fed announcement reversed this methodology by saying that they’d focus more on keeping the money supply fixed and let interest rates float more freely—the Fed Funds range was increased to 400bps at that meeting.

The Fed Funds Rate rose sharply in the months that followed this decision: it was close to 14% at the end of 1979, and reached past 19% in June 1981. The objective at the time was to fight massive inflation which averaged 14.6% from May 1979 to April 1980 (compared to -0.2% inflation from Oct 2008 to Oct 2009). It took two recessions—Jan-Aug 1980 and July 1981-Dec 1982—but by the end of the second one, the strategy of letting rates float higher worked to bring inflation below 4%.

It also gave birth to bond markets as we know them. Once a relatively straight forward, predictable market, bond markets became something that could be traded wildly since bond price and rate move inversely. Fast forward to today, this is why the fluctuating Fed Funds Rate is important as an overall rate barometer for the economy, but mortgage bonds are what determines mortgage rates.

Source material for those who want to read more on this Fed milestone is available here, here, and here).