Former US Treasury Secretary and Director of National Economic Council for President Obama

King’s College London

Professor David Aikman was joined by former US Treasury Secretary and Director of the National Economic Council for President Obama, Lawrence H. Summers (President Emeritus and Charles W. Eliot Professor at Harvard University) for a keynote discussion at the International Finance and Banking Society 2021 Oxford Conference titled ‘Financial System(s) of tomorrow’.

qcgbf lawrence summers
David Aikman, Director of the Qatar Centre for Global Banking and Finance with Lawrence H. Summers, President Emeritus and Charles W. Eliot Professor at Harvard University.

Lawrence H. Summers discussed the inflation outlook in the US and how overheating and inflation pose the greatest risk to the US economy. Watch the recording of the discussion below or continue reading to find out his insights into the currents macroeconomic outlook and its policy implications.

The topic of the day has been the inflation outlook both in us and around the world, where we’ve seen large increases in inflation in many countries this year. Just this morning, in the UK, the CPI inflation read is the biggest on record, going back to when the Bank of England was granted independence for monetary policy in 1997. You’ve been very vocal about your view that overheating and inflation are the predominant risks to the US economy. Central banks on the other hand, are pretty sanguine about this risk, as they view it as a transitory affair. Could you start by giving us your views and why you think this could be a more persistent phenomenon than central banks expect?

I think all of us, particularly when we’re in policymaking positions, tend to want to make different mistakes rather than mistakes we’ve made before. Over the last 40 years, the dominant mistakes have been overly worrying about inflation and being too restrictive for too long. Those were certainly the mistakes that were made in the wake of the financial crisis. The inflation alarmists (of whom before now I’ve never been one) have pretty consistently been wrong. And inflation has been low and constant for nearly 40 years, which means almost any econometric approach will conclude that there’s nothing that reliably predicts increases in inflation. Because if you regress a constant term on any set of variables, you’re going to get zero coefficients. So, I think the intellectual environment, both in terms of the past experience of policymakers and the nature of the era that’s considered relevant for statistical study, imparts a very substantial bias towards serenity. I think that there is a tendency, and you know a great deal of error in statistics, comes from excessive emphasis on a particular null hypothesis.

Something similar is true for policymaking. We tend to go with a null hypothesis which is what we thought before until it’s been proven to be wrong, at which point it’s often too late to respond optimally. It’s like all of these tendencies are running through central bank thinking. I think they’re reinforced by the fact that there was an immediate imperative of providing liquidity, providing aggregate demand, and providing economic support in the wake of Covid. People who have an imperative tend to lose it somewhat slowly. All of those things, along with the natural human desire not to inflict pain and not be seen as a pain inflictor, all of that contributes to it being natural, that if inflation were a problem, there might well be a tendency at this moment to miss it and to respond belatedly.

If I look at the US economy, it seemed clear to me that when the gap in terms of lost incomes was running at about $30 billion a month below the previous trend, it seemed to me obvious last January, that when we had a program that represented about $200 billion a month in stimulus, that was coming on top of a $2 trillion savings overhang. It was coming on top of record expansionary monetary policy. It seemed to me that we were headed for the bathtub overflowing. Demand very substantially exceeding trend or potential output, to the extent that there was supply impairment because businesses closed, there were early retirements, people couldn’t get to work and certain sectors had to close. That only reinforced the bathtub overflowing by shrinking the capacity of the bathtub. So, it seemed to me that there was a presumption that the bathtub was going to overflow. Nothing that has happened since then has changed that presumption in my mind at all.

What has mostly happened is that we’ve had more evidence of more inflation more promptly than I would have expected, and so core CPI inflation in the US ran at a double-digit rate in the first and second quarter of the year. Of course, lots of that is transitory, so no one is suggesting that there aren’t any transitory factors generating inflation. But the question is whether a norm is being established that is significantly above the 2% inflation target? That’s what happened in the face of a much smaller fiscal expansion in the 1960s, setting the stage for the great inflation of the 60s and the 70s. Then, the swing in fiscal policy was a quarter of what it has been in the last years, so I think we have seen has been pretty rapid inflation.

Now, of course, it’s true that price increases across sectors are not even. But if you imagine that demand was being over expanded in a way where it collided with supply, what would you expect? You would expect that there would be some sectors where there would be major bottlenecks, and they would have particularly large increases in inflation. And that’s kind of what we have seen. Is all this going to end? Is it going to end quickly? Is inflation going to return to normal consistent with a rapidly growing economy? Maybe, but it’s interesting that the median inflation, the thing that strips out all the outliers that people used to emphasise, had its worst month in 14 years last month, so that’s not so encouraging. The businesses I talk to and the surveys of businesses report that people now think bottlenecks will be part of their economic environment until mid-2022. But the two biggest markets in the economy, the labour market, the housing market, both it seems to me are cause for alarm. Nobody disputes that the labour market’s getting tighter and tighter, and yet already we’ve got the highest vacancy rate we’ve ever seen in the United States and the lowest rate at which employers can fill vacancies that we’ve ever seen in the United States. That seems to meet presage wage acceleration.

Now we look at the housing market. House prices are up almost 20% year on year. If you look at new tenants moving into rented housing, they’re paying 17% more than the previous tenant did. That tells you that we’ve got some rapid housing inflation, and that’s the largest component of the CPI. It’s not in the statistics yet, but either it’s coming in the statistics, or it says something about the quality of the statistics. Nobody can really argue that housing costs aren’t going up very substantially.

So I look, and I see more tightness in labour markets, more pressure coming from housing markets, continued presence of bottlenecks, more fiscal policy coming online, and no plans to raise interest rates until 2023 and a change in the Fed’s doctrine from “we’re going to remove the punch bowl before the people get plastered” to “we’re going to remove the punch bowl only when we’re absolutely sure that many people are getting plastered”. It seems to me that people are going to be revising their view about inflation expectations upwards. I could be wrong of course; demand could create its own supply. We could have some substantial interruption in economic activity from some other source. I don’t think Covid is going to be enough to make me wrong, because at this point, more Covid is acting as much as a supply shock as it is a demand shock and therefore it could be a potential contributor to inflation.

So, I’m pretty worried about the inflation picture right now. It’s remarkably reminiscent to me of the 1960s. First, there’s denial that there’s inflation, then there’s the explanation that inflation’s due to a set of special factors. Then there’s an increasing view that maybe some inflation’s okay, or at least inflation’s okay relative to the consequences of trying to curtail inflation with policy, so I’m anxious. I have to say this is a financial conference. I have to say I’m quite surprised and puzzled that my concerns are not more manifest in the bond market. Break-even inflation rates have indeed picked up, but they haven’t picked up that much, and I’m not with a completely clear explanation as to why that is.

You mentioned policy framework changes. The Fed changed its framework, and it’s now committed to allowing inflation to overshoot two per cent, to make up for past undershoots. The motivation for this was all looking back to when we had deflationary pressures as the primary concern, the proximity of the effective lower bound and so on. Are you concerned, though, that this change risks baking in the Fed being behind the curve? Is it well equipped to deal with the risks that you see?

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