Larry Summers, a Harvard economics professor and former Treasury secretary, has decisively won the inflation debate against Nobel Prize-winning New York Times columnist Paul Krugman.
That debate, between Krugman, who thought inflation would be temporary, and Summers, who expected inflation to be high and difficult to control, has had important implications for investors.
For much of 2021, it seemed like the Krugman camp was winning the debate. However, in early November it became clear that Fed Chairman Jerome Powell would be nominated for another term.
That move signaled that Powell would be tasked with reining in inflation and ushered in a sectoral rotation away from fast-growing tech stocks toward cyclical industries that would be more likely to benefit from higher interest rates.
Summers argued that the markets. forecasters, pundits and the Fed were wrong to say that inflation would dissipate once supply chain problems eased. He saw that “President Biden’s American Rescue Plan [was] too much stimulus too fast” and that it would not be limited to cars and energy, according to the New York Times.
With inflation reaching levels not seen in 40 years, for example, personal consumption expenditures rose 6.4% in February, according to the Wall Street Journal — and the Federal Reserve projecting six more interest rate hikes in 2022 — “the most aggressive pace in more than 15 years” — Summers seems to have won the inflation debate decisively.
These are what I consider to be three of Summers’ most important insights and the implications for investors.
The Fed will raise rates to 4% or 5%
The Fed’s aggressive plan to raise rates starts from a base near zero. On March 16, the Fed raised its fed funds rate 25 basis points to a range of 0.25% to 0.50%. Summers expects that rate to rise to 2% by the end of 2022 (10 basis points above consensus), according to CNBC.
Summers sees the fed funds rate rising much higher, to between 4% and 5%, “in the next few years,” he told the Times. What I found interesting was his reasoning for the rate increase.
Summers highlighted the idea that people make decisions based on inflation-adjusted interest rates rather than the nominal rate. Bottom line: With inflation in the 6-7% range and the fed funds rate at less than 1%, the current real interest rate is deeply negative.
Until the real interest rate is positive, people will make economic decisions on the assumption that their purchasing power will decrease the longer they wait. This expectation brings out the hoarding instinct: people rush to buy as much as they can now because they expect the purchasing power of their money to decline over time.
Summers also argued that in order to convince people to save rather than spend, the real interest rate must be positive. If Summers expected inflation to continue rising at a 6%-7% rate in a few years, the Fed would have to raise rates above the 4%-5% range he expects.
Inflation expectations are low now, but could rise
Summers is implicitly saying that in the future, inflation will be lower than it is today, in the range of 4% to 5%.
Last year, when he was a lone voice arguing that inflation would not go away after the pandemic was over, he saw US wage inflation rise more than 6% due to labor shortages. That was before recent Covid-related lockdowns in China intensifying supply chain problems and the Ukraine war that has pushed oil prices to record highs.
So why does Summers think inflation will come down in the future? That is why he acknowledges that Krugman is correct in pointing out that “as of now people are forecasting very fast inflation for this year. The market forecast is close to 6% [— with the $25 to $30 a barrel oil price increase contributed 1% to 1.5% to that rate —] but they still forecast more limited inflation beyond that,” he told the Times.
I’m not sure how to explain why Summers implicitly expects the inflation rate to fall to 4% or 5% from the current level of 6% to 7% in the next few years. Do investors think the Fed will do whatever it takes, maybe raise interest rates faster and faster than it has already said it would?
If not, the reason could be that people still believe the argument that prevailed for much of last year that inflation would be a temporary problem.
However, I sympathize with the case that we are in a spiral of wages and prices that could only end if there is a massive recession that causes the unemployment rate to rise.
Unless that happens, it seems to me that with demand exceeding supply, businesses will be able to raise their prices substantially and people enjoying 6% wage increases as the unemployment rate remains very low. at 3.6% (0.2 percentage points below the February rate): they will continue to buy.
Economists have generally considered increases in food and fuel prices to be much more volatile than inflation in labor rates. Once labor rate inflation kicks in, reversing inflation becomes more difficult. How is that? To retain workers in this environment, business leaders are likely to keep raising prices and wages.
Immigration could help curb wage price spiral
Absent a recession that puts enough people out of work to reduce demand, are there policy actions that could bring inflation expectations back below the 2% target the Fed has been targeting for the past decade plus? or less?
Summers wants to increase the supply of workers, which would presumably reduce the pressure to raise wages. As he told the Times, this would include admitting more immigrants, both highly-skilled and less-skilled, to the US. He sees boosting immigration as a way to contribute substantially to economic growth “without harming the interests of American workers.” .
I’m glad Summers brought this up. On February I wrote that boosting immigration would help reduce inflationary pressures. I certainly hope that something can be done to prevent a repeat of what Paul Volcker did 40 years ago: raising the prime rate from an all-time high of 11.75% to 21.5%.
I don’t see immigration barriers going down in the US and expect inflation expectations to rise. With unemployment so low, I think long-term inflation expectations – Citicorp expects rates to rise to 3.75% by 2023 – are likely to rise and that means the Fed will have to raise interest rates much higher than the level Summers expects.
This does not bode well for stock investors. But if stocks continue to slide, it could trigger a reverse wealth effect in which the 56% of Americans who own stocks, according to Gallupthey will feel poorer and therefore reduce their expenses.