I met US Fed chief Paul Volcker and this is what he told me about the future of the world economy

Paul Volcker, who died on Sunday aged 92, was the person who, more than anyone else, saved the world economy from the runaway inflation of the 1970s. It is quite hard now to appreciate the threat that inflation then posed – until you remind people that the retail price index went up by 24.9 per cent in 1975 or how workers went on strike through the 1970s and 1980s to try and claw back the loss of the value of their wages.

Inflation was a global problem, but to an even greater extent than now, the US dominated world finance. If America could get inflation down, the rest of the world would follow. So when Paul Volcker was appointed by President Jimmy Carter to be chair of the Federal Reserve Board in 1979, he was the person who had to take on the task.

He did so by increasing interest rates, pushing the key short-term rate – the Fed funds rate – up to 20 per cent in 1980 and again in 1981. Rates around the world rose too. At the end of 1979 the Bank of England’s base rate was 17 per cent, which meant that anyone who had a variable mortgage rate was paying 18 per cent or more. High rates were part of the cause of the early 1980s recession, but the policy worked. Eventually inflation was crushed, the world economy recovered and by the end of the 1980s it was booming.

So what would Paul Volcker say about our present condition, where inflation in Europe (though not so much in the US or UK) is deemed too low, and official interest rates are actually negative?

Well, we can catch some feeling for this from his book Keeping At It, co-written with Christine Harper, but by coincidence I had a personal glimpse of his views on inflation when he came and stayed with us in Oxford 2005.

He had come over to give the Cairncross Lecture at St Peter’s College, where my father-in-law, the economist Sir Alec Cairncross, had been master. My wife, Frances Cairncross, who at that stage was rector of Exeter College, invited him to stay with us instead – he was 6ft 7in tall and I think we had a longer bed. So later that evening we sat around the fire, he stretched out his legs and he talked about the role of central banks.

The key thing I remember from the conversation was just how hostile he was to inflation targets – then, as now, the guiding indicator for interest rate policy. He felt that central banks had become obsessed by them and that would lead to policy mistakes. What should they aim at instead? Stability, he replied.

Now remember the context. In 2005, the world was less than three years away from the most serious financial crash since the 1930s. At that time, we can now see, the central banks were lulled into complacency about the explosion of credit because inflation was benign. But global prices were held down by the flood of cheap manufactured goods from China to the developed world, particularly the US. The central banks, especially the Fed, were looking in the wrong direction.

So what about now?

He wrote and spoke in interviews about the central banks’ over-reliance on inflation numbers since then on other occasions. But he has not, as far as I can see, commented publicly on the European Central Bank’s policy of negative interest rates, where the banks have to pay to leave cash on deposit with the ECB. It would in any case be improper for a former head of one central bank to criticise the policies of another one.

However, I think we can infer what he might have said. The first point would be that the cause of below-target inflation in Europe is at least partly because of falling costs as a result of the communications revolution. Technology is doing now what China did to prices 15 years ago. Does it matter that inflation is so low in Europe? If people get an increase in their living standards from lower prices, surely that is beneficial?

The second point would be emphasising the need for stability. He was asked in 2009 to recommend how the banking system should be reformed to prevent another meltdown and came up with the so-called “Volcker Rule”, prohibiting banks from carrying out speculative activities.

But that is not the problem in Europe now. The problem, which also applies in the US to some extent, is partly that very low interest rates have encouraged investors to go for riskier ventures, and partly that cheap money has pushed up asset prices, perhaps to unsustainable levels.

Put bluntly, it is overly cheap money that threatens stability. As he wrote in a column for Bloomberg a year ago: “The real danger comes from encouraging or inadvertently tolerating rising inflation and its close cousin of extreme speculation and risk taking, in effect standing by while bubbles and excesses threaten financial markets.

“Ironically, the ‘easy money’, striving for a ‘little inflation’ as a means of forestalling deflation, could, in the end, be what brings it about.”