Former U.S. Treasury Secretary Lawrence Summers said that the U.S. economy could be headed for stagflation and then eventual a recession if the Federal Reserve continues on its current policy trajectory.
The Fed kicked off a series of interest rate hikes on March 13 in an effort to steer the economy out of the heightened inflation and effects of Russia’s invasion of Ukraine. The Federal Open Market Committee raised its benchmark interest rate by 0.25 percentage points, ending the near-zero interest rates of the pandemic era with a cycle of rate increases expected to last well into 2023.
Inflation is at a 40-year high in the U.S., with soaring energy rates and raw material prices expected to lead to a possible economic slowdown.
In its effort to limit the economic damage from the pandemic, the Fed undertook a broad array of actions to keep credit flowing. These included making large purchases of U.S. government and mortgage-backed securities, and lending money to support businesses, households, employers, financial market participants, and state and local governments.
The Fed has been criticized for some of these actions.
In an opinion piece published by The Washington Post, Summers described Fed Chair Jerome Powell’s optimism around taming inflation as “wishful thinking”.
“I believe the Fed has not internalized the magnitude of its errors over the past year, is operating with an inappropriate and dangerous framework, and needs to take far stronger action to support price stability than appears likely,” Summers wrote.
After serving as secretary of the treasury under President Bill Clinton, Summers was president of Harvard University from 2001 to 2006. From 2009 to 2011, he headed President Barack Obama’s National Economic Council.
“The Fed’s current policy trajectory is likely to lead to stagflation, with average unemployment and inflation both averaging over 5 percent over the next few years — and ultimately to a major recession,” Summers wrote.
In February 2022, St. Louis Federal Reserve President James Bullard warned that inflation could get out of control and called for a whole percentage point in rate increases by July 2022 to stem inflation.
The Fed indicated it would begin to increase interest rates in March, the first increase since 2018.
Summers said that while the Fed needs to prioritize price stability to sustain employment, the reality is that real short-term interest rates will have to rise above 5 percent to stave off a recession — and markets currently think that number is “unimaginable”.
“I hope the Fed will make clear that inflation reduction is its principle objective, and that it will wind down efforts to promote worthy but non-monetary goals such as social justice and environmental protection,” wrote Summers.
“This implies committing to doing whatever is necessary with interest rates to bring down inflation, including movements of more than a quarter-point at some meetings and a rapid reduction of its balance sheet,” Summers added.