Larry Summers, who served as treasury secretary under President Bill Clinton and director of the National Economic Council under President Barack Obama, has issued a stark warning that inflation, rather than “excessive slack” in the economy as it bounces back from the pandemic recession, has now become the chief risk.
Summers penned an op-ed in The Washington Post on May 24, in which said that “even six months ago, it was reasonable to regard slow growth, high unemployment, and deflationary pressures as the predominant risk to the economy.”
But the recent stream of economic data, including a sharp rise in the consumer price index, record-high levels of job openings, business hiring difficulties, growing wages, and an economy growing at its fastest pace in decades, strongly suggest that inflation is looming ever larger as the key risk, he argued.
“Now, the primary risk to the U.S. economy is overheating—and inflation,” he wrote.
“This is not just conjecture,” Summers wrote. “The consumer price index rose at a 7.5 percent annual rate in the first quarter, and inflation expectations jumped at the fastest rate since inflation indexed bonds were introduced a generation ago. Already, consumer prices have risen almost as much as the Fed predicted for the whole year.”
Inflationary pressures are growing due to a demand boost fueled by some $2.5 trillion in savings households have built up during the pandemic, trillions of dollars in federal fiscal stimulus, frothy equity, and real estate markets, and the Federal Reserve’s asset purchasing program and commitment to keeping rates near zero into 2024, he said.
While crediting the “aggressive” COVID-19 containment policies and “strong” fiscal and monetary policies for helping the U.S. economy recover faster than other industrial nations from the pandemic lows, Summers cautioned that the newly emerging conditions, including labor shortages and projections that suggest unemployment could fall below four percent over the next 12 months, “require new approaches” from policymakers to sidestep a sharp economic contraction.
“Starting at the Fed, policymakers need to help contain inflation expectations and reduce the risk of a major contractionary shock by explicitly recognizing that overheating, and not excessive slack, is the predominant near-term risk for the economy,” he said.
“Tightening is likely to be necessary, and it is critical to set the stage for that delicate process,” he added, referring to the Fed’s monetary policy, currently “loose” and expansionary with rock-bottom interest rates and aggressive bond buying.
‘Talking About Talking About Tapering’
Summers’s warning comes as Fed policymakers have begun to acknowledge they are closer to debating when to pull back some of their crisis support for the economy, even as they say it is still needed to bolster the recovery and employment.
“We are talking about talking about tapering,” San Francisco Federal Reserve Bank President Mary Daly told CNBC on Tuesday, referring to the potential reduction of the Fed’s $120 billion in monthly asset purchases. Those bond buys, together with near-zero interest rates, are aimed at easing borrowing costs and encouraging hiring and investment.
“I want to make sure that everyone knows that it’s not about doing anything now,” Daly added. She noted that while she is “bullish” about the fall, the economy is still more than 8 million jobs short of where it was before the pandemic, which is still not over. “Right now, policy is in a very good place … we need to be patient.”
Earlier Tuesday, Fed Vice Chair Richard Clarida also opened the door to talking about the Fed doing less—at some point. “It may well be … there will come a time in upcoming meetings we will be at the point where we can begin to discuss scaling back the pace of asset purchases,” Clarida told Yahoo Finance. “That was not the focus of the April meeting. It is going to depend on the flow of data.”
This suggestion that talking about tapering could become appropriate is a shift from just a month ago when Chair Jerome Powell said it was “not yet” time to even contemplate having that conversation.
Fed policymakers have promised to give markets plenty of notice before changing policy, to avoid a repeat of the “taper tantrum” spike in bond yields after former Fed Chair Ben Bernanke surprised markets by flagging a reduction to the Fed’s bond-buying in 2013.
Since their April meeting, two regional Federal Reserve bank presidents have publicly urged that the discussion begin soon, and others have highlighted the risks should a current round of price increases become a more embedded cycle of inflation.
The Fed has promised it won’t raise rates until the economy is back to full employment and it sees inflation reach two percent and poised to rise above that level.
That stance worries some economists, including Summers, who believe the Fed has become too relaxed about inflation and is setting the stage for a painful round of abrupt, inflation-fighting interest rate increases that could also push the economy back into recession.
Most Fed policymakers have stuck to the view that the recent rise in inflation will prove transitory, blaming rising prices on supply and labor market bottlenecks that will in time get worked out.
But not all Fed officials are fully convinced. Speaking late Monday, Kansas City Fed President Esther George noted the “tremendous” amount of fiscal stimulus that has been pumped into the economy and said she is “not inclined to dismiss today’s pricing signals or to be overly reliant on historical relationships and dynamics in judging the outlook for inflation.”
Clarida on Tuesday said he believes that the Fed will be able to curb any outbreak of inflation with tough talk and more modest rate hikes that would allow economic growth to continue.
The Fed will get new inflation data on Friday, with forecasters expecting that prices for personal consumption goods excluding food and energy rose at a 2.9 percent annual rate in April. That would be the highest reading since June 1993 and beyond the Fed’s two percent inflation target.
Reuters contributed to this report.