The Federal Reserve is guilty of monetary policy malpractice, aided and abetted by Congress’ bipartisan support of the administration’s massive pandemic relief spending.
That, in a nutshell, is Larry Summers’ assessment of why inflation is running hotter than it has in more than 40 years. Of course, the Harvard economist and former Clinton administration treasury secretary deployed far more prudent phrasing in an interview this week as he discussed how we’ve gone from post-pandemic boom to risk of recession in less than two years.
The Fed’s job is to keep demand in line with supply so that prices don’t spiral out of control, said Summers, who was considered President Obama’s top choice to run the central bank in 2013 before taking himself out of the running when it didn’t look like he had support from progressives in his party. “Inflation means that has not been done in a satisfactory way,” he told me.
Throughout much of last year, Summers was a lonely voice raising the alarm about the potential downside of President Biden’s American Rescue Plan. His contrarian view: The $1.9 trillion spending package was overkill, especially with Fed Chairman Jerome Powell keeping interest rates at near zero since the start of pandemic.
“There is a chance that macroeconomic stimulus on a scale closer to World War II levels than normal recession levels will set off inflationary pressures of a kind we have not seen in a generation,” he wrote in a Feb. 4, 2021, column in The Washington Post.
At the time, most of the economic establishment said his warning was too dire. The engaged citizen in me liked Biden’s aggressive approach to the pandemic economy and Powell’s handling of the crisis.
Now, listening to Summers a year on, I’m thinking, yeah, he nailed it — for the most part.
When Democrats pushed the American Rescue Plan through Congress in March 2021, inflation was running below the Fed’s 2 percent target. But by summer, consumer prices were up 5 percent over the previous year; last month inflation hit 8.5 percent, the highest since 1981, the Labor Department said on Tuesday.
Powell, believing the spike in prices would subside as the pandemic faded, was slow to change course. As a result, inflation has gone from benign to malignant, a serious threat to the economy that has boosted the chances of a recession unless the Fed plays its cards just right.
Summers, 67, has been in high demand as the media swarms the inflation story. In my interview and others, including recently with Ezra Klein of The New York Times and John Cassidy of The New Yorker, he has laid out his outlook for the economy and taken the Fed to task.
A former chief economist at the World Bank, Obama’s top economic adviser, a past president of Harvard — Summers is perhaps more qualified than anyone to serve as de facto shadow Fed chairman. He’s a centrist Democrat. Many in the party’s progressive wing distrust him because of his work with big banks and hedge funds, and his critique of Biden’s stimulus spending.
While giving Summers credit for his prescience, let’s remember that the cost of living has risen sharply due in part to factors that neither he nor the Fed could have foreseen. The Delta and Omicron surges caused global economic havoc, as have Russia’s invasion of Ukraine and the sanctions imposed by the West in response. Absent these factors, inflation probably wouldn’t be the front-page problem it is today.
So where do we go from here?
Like other economists, Summers saw some positive news in the Consumer Price Index report for March, which was released on Tuesday. Most notable: price gains excluding the volatile food and energy categories slowed from February. With energy costs now falling, last month may have marked the peak of this inflation outbreak, he said.
But hold the high fives. Inflation has a long way to fall to reach the Fed’s comfort level.
“It’s likely that annualized CPI will decline from the 8.5 percent level,” Summers said. “That’s very different from inflation being under control.”
Which means inflation is going to hang around like a boorish party guest.
“These problems were not made in a week or a month,” Summers said. “They will not be solved in a week or a month.”
To tame inflation, Summers believes borrowing costs will have to move much higher than the Fed has signaled.
In its latest projections, the median estimate of central bank policy makers put the benchmark federal funds rate at 2.8 percent by the end of next year. The rate currently is 0.5 percent, after a quarter-point increase last month, the Fed’s first since 2018.
Summers thinks a fed funds rate of up to 5 percent will be needed to get real rates — that is, adjusted for inflation — meaningfully above zero. Only then will the cost of borrowing money be steep enough to cool off the economy.
That degree of credit tightening is hard to pull off without going too far or too fast and inadvertently pushing the economy into a recession.
The cost of borrowing to buy a house has already climbed substantially, with the average rate on a 30-year fixed mortgage reaching 5 percent this week for the first time since 2011, according to Freddie Mac.
The housing market could be the canary in the coal mine for whether higher rates lead to a soft or hard landing for the economy.
Summers is now saying the odds of a downturn are about two-thirds within two years.
I hope he’s wrong this time.