How An Old Banking Regulation May Have Driven The 1970s Inflation

Episode Summary

Executive Summary: The episode revisits 1970s inflation with economist Itamar Drexler, who argues the common Fed/expectations story misses a key driver: Regulation Q, which capped bank deposit rates. When ceilings bound, deposits fled banks, credit tightened, firms faced working-capital shortages, and both supply and demand dynamics pushed inflation higher. He says deregulating Reg Q helped end the era and offers lessons for today’s weak deposit-rate pass-through.

Main Topics: Reassessing the 1970s inflation narrative: The hosts challenge the standard view that the Fed simply failed to crush inflation expectations, arguing the decade’s persistence needs a deeper explanation than oil shocks and weak policy response. Regulation Q and deposit-rate ceilings: Drexler explains how Reg Q capped the interest banks could pay on deposits, creating a wedge between market rates and deposit rates once inflation and the Fed funds rate rose. Disintermediation and credit rationing: When depositors moved money out of banks, banks lost funding and rationed credit, especially to credit-constrained manufacturers that needed working capital to operate. Supply-side inflation through firm constraints: The guest argues credit shortages raised production costs, reduced output, employment, investment, and inventories, helping explain stagflation as a supply-driven inflation episode. Demand-side effects and the ‘hot potato’ of money: Low real deposit returns also discouraged saving and encouraged consumption, but Drexler says this demand effect was smaller than the supply impact overall. Volcker, deregulation, and the end of inflation: Drexler contends the durable disinflation was helped not only by Volcker’s rate hikes but also by staged deregulation of Reg Q, which restored deposit inflows and eased credit conditions. Lessons for today’s inflation and banking transmission: The episode compares 1970s credit frictions with today’s low pass-through on deposit rates, the role of banks in credit creation, and why supply-chain or supply bottlenecks still matter.

Key Arguments: The standard 1970s narrative says the Fed failed to raise nominal rates enough above inflation, letting expectations de-anchor; Drexler argues that view is incomplete. Regulation Q capped deposit rates, so when market rates rose banks could not compete for deposits, causing disintermediation and credit crunches. Credit shortages hit firms’ ongoing operations, not just investment: firms needed working capital to pay labor and materials upfront, so rationed credit reduced supply. The data show a clear timing link: when the Fed funds rate exceeded the Reg Q ceiling, deposits flowed out, unfilled orders rose, and inflation increased while output fell. Cross-firm evidence indicates more credit-constrained manufacturers raised prices more and cut output, employment, investment, and inventories more than less-constrained firms. The demand-side effect existed because low real deposit returns pushed consumers toward spending, but the supply-side channel dominated in the aggregate. Volcker alone is not the whole story; Reg Q deregulation in 1978-79 and 1982 also corresponded with deposit inflows and declining inflation. Today’s weak deposit-rate pass-through is different because banks have market power and can choose not to raise rates, unlike the binding legal constraint of the 1970s.

Data Points: Reg Q ceiling duration: 1933 to 1965 mostly nonbinding; binding more meaningfully from 1965 onward - The Fed used Regulation Q to cap bank deposit rates, and it stopped adjusting the ceiling in line with rising market rates in the late 1960s. Fed funds vs deposit rates: Deposit rates barely reacted to the Fed funds rate in the 1960s and 1970s - A central empirical observation motivating the research and showing the ceiling’s binding effect. Inflation gap at times: Deposit rates were 7-9 percentage points below inflation - Example of how negative real returns on deposits made saving unattractive during peak inflation. Deposit ceiling level: About 5% to 5.5% - Ceiling mentioned in contrast with inflation reaching 14%. Peak inflation: 14% - Used to illustrate how badly capped deposit rates lagged inflation. U.S. firms with bond access today: About 1,000 out of 3,500 listed firms - Shows most firms still rely on bank-like credit rather than bond markets. U.S. firms with bond access in late 1970s: About half as many as today out of about 4,500 listed firms - Used to argue banks were even more important as credit providers in the 1970s. Firms with over 20 employees today: About 700,000 - Most cannot issue bonds and still depend on banks or bank-like credit. Firms with over 20 employees in the late 1970s: About 350,000 - Illustrates the smaller scale of the corporate sector then, but still limited bond-market access. Timing of Reg Q deregulation: First major deregulation in 1978-79; largely removed by end of 1982 - Drexler argues these steps align with the durable decline in inflation. Money-market/banking innovation period: Late 1970s to early 1980s - Time when money market mutual funds and Eurodollars expanded as financial innovation responded to Reg Q.

Pivotal Quotes: "The most common narrative is that the Fed... did not really respond aggressively enough to increases in inflation by raising the Fed funds rate as later policy would dictate." — Itamar Drexler: Summarizing the standard macroeconomic explanation he is challenging. "When they raised interest rates, because this gap grew, deposits were flowing out. It's the clearest thing in the data." — Itamar Drexler: Explaining the core empirical mechanism linking Reg Q to disintermediation. "It was better than the Volcker rate hike with the two stages of the deregulation of Reg Q." — Itamar Drexler: His provocative claim that deregulation was at least as important as Volcker’s hikes in ending inflation.

Implications: The episode suggests inflation can be driven as much by financial frictions and supply constraints as by excess demand. For today, it warns that weak deposit-rate pass-through and credit bottlenecks can distort policy transmission and that supply-side indicators still matter.