I am sure that Larry Summers would have preferred not to have seen today’s inflation numbers, but he might just have felt a flicker of satisfaction at further confirmation that he has been on the right track about rising prices.
Under the circumstances, it’s worth scrolling back a few days and seeing what Summers was quoted by Bloomberg as saying last week:
Former Treasury Secretary Lawrence Summers said that even after the Federal Reserve’s recent hawkish pivot and after a selloff in Treasuries, both policy makers and investors are still underestimating what will be required to bring down inflation.
“My own view is that the Fed and the markets are still not recognizing what’s likely to be necessary,” Summers said on Bloomberg Television’s “Wall Street Week” with David Westin. “The market judgment and Fed’s judgment is that you can somehow contain this inflation without rates ever rising above 2.5% in terms of the fed funds rate.” . . .
Summers, a Harvard University professor . . . said that if inflation did come down without the Fed hiking its target rate past 2.5%, that would only be likely if the U.S. economy had proved unable to cope with tightening of a lesser scale.
“What we’re going to find out is what the vulnerability of the economy is to rate increases,” Summers said. “It may be, as some argue, that because of greater levels of debt, because asset prices are substantially inflated, the economy is more vulnerable than usual to rate increases or to quantitative tightening.”
I would focus on that last sentence. Firstly, it raises the question of whether the Fed has the stomach to increase rates (or expectations of where they will go) to a level that may lead to a possible crash (a level that may not be that much higher than current expectations: Check out the turbulence in tech stocks) possibly extending beyond the financial markets into housing (even if, in the latter case, an underlying housing shortage may provide some sort of floor) and other asset classes.
Lurking ahead is the hobgoblin of financial crises. Central banks cannot reconcile tightening, to serve the needs of the economy, with ongoing accommodation, for wider financial stability. Super low rates risk financial bubbles and eventual turmoil. But super high rates risk popping those bubbles in calamitous ways. After years of quantitative easing, the incongruity between the monetary needs of the economy and the monetary needs of markets is inescapable.
Is the Fed prepared to risk (or tough out) a crash?
Then there is the question of what rate hikes might mean for the indebted. Summers is, I think, talking about private- and public-sector debt — and reasonably so. Nevertheless, given the level of debt that the U.S. has now incurred, I would particularly focus on public finances when looking at constraints on the Fed’s willingness to increase rates. In that connection (and taking a longer view), it’s worth taking a look at Brian Riedl’s excellent, but less than cheery, paper for the Manhattan Institute on, among other matters, the intersection between interest rates and federal debt. I wrote a bit about it here.
As a reminder, the latest inflation levels are the highest since 1982. At that time Paul Volcker’s squeeze was already being reflected in the numbers — inflation was falling — but it is not particularly comforting to recall that the then-chairman of the Fed’s cure had involved the Fed Funds rate peaking three times at 20 percent. That’s not going to happen in the current cycle, and nor (at our current debt levels) could it in any foreseeable cycle, without disaster ensuing.
Monetary policy lives in the shadow of debt. US federal debt held by the public was about 25% of GDP in 1980, when US Federal Reserve Board Chair Paul Volcker started raising rates to tame inflation. Now, it is 100% of GDP and rising quickly, with no end in sight. When the Fed raises interest rates one percentage point, it raises the interest costs on debt by one percentage point, and, at 100% debt-to-GDP, 1% of GDP is around $227 billion.
Read the rest of Cochrane’s piece if you want to ruin what little joy is left in your day after Riedl has done his worst.
There seems to be little doubt that the Fed now realizes that it has left things . . . a little late.
The [inflation] data, which were released by the BLS on Wednesday, come just a day after Jay Powell, chair of the US Federal Reserve, warned high inflation was a “severe threat” to the labour market recovery and affirmed the central bank’s intentions to rapidly reduce its monetary policy support.
“The Fed is now behind, so the urgency you hear in Powell’s voice on inflation is him playing catch-up,” said Tom Porcelli, chief US economist at RBC Capital Markets. “The justification for the Fed to respond to inflation happened months ago.”
Summers believes that inflation is unlikely to come down to where the Fed would like it to be without rates going above 2.5 percent. But, given both concerns about the markets and, I’d guess, even more so, the level of government debt, it is hard to imagine that the Fed will be prepared to let rates (or expectations of rates) get that “high” (in real terms, of course, 2.5 percent is anything but high).
Here’s a little statistic from Claire Jones at the FT:
The federal funds rate is now about eight percentage points lower than it was the last time inflation was north of 6 per cent.
While (and I am not alone in this) I would not be surprised to see a somewhat sharper slowdown than some expect, I don’t think that a recession is likely in the near term. The Fed will increase rates, but not in a way that suggests that they are going above 2.5 percent. Additionally, some of the elements contributing to our current inflationary surge, from supply-chain disruptions to the labor shortage, ought to fade leading (in the middle of the year?) to an easing in inflation, at least for a while, meaning that prices are unlikely rise to the the extent that demand is crushed. Put these two factors together, and we can expect to have to live with higher levels of inflation for longer than Washington would like us to believe, something to which factors such as energy costs and “shelter” (housing and its derivatives) could well be significant contributors.
Whether all this will prove to be a prelude to stagflation is an intriguing question for another time, unless those who seem set on greenflationary policies would like to chip in with their thoughts now.
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