Summers warns of ‘economic distress’ as Fed Chair Powell comments hope

“Unless we have a bunch of very surprising and positive developments,” Summers told Politico, “It is unlikely that we will see the inflation rate fall to an extreme [the Fed’s] target without there being some level of purposeful economic distress.” Summers, who was also a senior adviser in the Obama White House, ridiculed the Fed’s previous forecasts as “delusional.”

The result has far-reaching implications for the country, including countless American families who have benefited from an extraordinarily strong labor market, but have also faced historic price hikes that devour wage increases and household budgets. It also presents a formidable challenge to Joe Biden’s presidency, as miscalculation by the Federal Reserve could lead to a deteriorating economy, persistently high inflation, or worse than both.

While the Fed in June saw the unemployment rate hit 4.1 percent by the end of 2024, some economists say it may need to rise to nearly 6 percent, and stay there for some time, to bring down inflation — an increase that will undoubtedly coincide with recession.

It is no longer a question of whether the Fed can avoid a recession, but whether it will accept a moderate slowdown that brings down inflation slowly, or a larger deflation that does the job quickly, said Diane Sonk, chief economist at KPMG.

“The optimal scenario for the Fed is that we get there with a modest increase in unemployment,” Sonk said. “I think within the Fed, there is some recognition that it could be more than that.”

The Labor Department reported Friday that employers added 528,000 jobs in July, well above economists’ expectations. The unemployment rate fell to 3.5 percent.

However, it is clear that broader economic activity has slowed. The government said last week that gross domestic product fell in the second quarter, after a decline in the first three months of the year, raising fears of an imminent recession.

Meanwhile, Powell is under pressure from some left-leaning economists and politicians, such as the senator. Elizabeth Warren (DE MA), who argue that the Fed’s campaign to raise interest rates will do little to quell inflation that has been driven largely by supply shocks such as the war in Ukraine and the Covid lockdown in China. In an op-ed in the Wall Street Journal last week, Warren also criticized Summers as an “encouraging leader” for higher rates and “someone who never worried where his next paycheck would come.”

Other skeptics say the Biden administration and Congress should do more to help the Fed control rates and avoid disrupting the economy.

“A recession will not help us tackle inflation — a recession will only hurt working families,” the senator said. Sherrod Brown (D-Ohio), Chairman of the Senate Banking Committee. “We need to bring down prices for workers and families, and tackle inflation at its source — and that means fighting corporate price gouging and consolidation, expanding our housing supply and investing in our supply chains.”

Democrats are preparing to push legislation soon, after the Senate Majority Leader negotiated it Chuck Schumer and age. Joe Mansion (DW.Va.), which they say will help ease price pressures by reducing the federal budget deficit — although some forecasters estimate the impact on inflation will be minimal and not materialized immediately.

Powell says the Fed does not have the luxury of ignoring supply constraints and hopes that inflation will come down on its own. He stressed that policy makers will not hesitate to slow growth or weaken the labor market as they continue to raise rates.

“These are things that we expect, and we think are probably necessary … to be able to get inflation back on track to 2 percent and eventually get there,” he said at a press conference last month.

How long will the pain take?

Summers likened the process to an addict going through a detoxing phase – it would include some withdrawal symptoms. For now, the Fed still expects these symptoms to be mild, though Powell acknowledged that the path to avoiding a recession has narrowed.

In June, Fed officials expected the inflation rate to fall from 5.2 percent at the end of this year to just over their target of 2 percent by the end of 2024. At the same time, they expected the unemployment rate to rise only half a percentage point. . point, to 4.1 percent from 3.6 percent in June.

Part of their optimism reflects a view among officials that the decline in job vacancies could take some heat out of the labor market and help ease price pressures without increasing unemployment too much.

As the economy slows, employers usually back off hiring and start laying off employees. But with so many job vacancies relative to the supply of available workers, Federal Reserve officials predict that the drop in employment will not necessarily correspond to a significant rise in the unemployment rate this time around.

Not everyone is convinced.

in last month’s paperThe Fed’s hope is “flying in the face of theoretical and empirical evidence,” said former IMF chief economist Olivier Blanchard and Harvard research fellow Alex Dumasch and Summers. Going back to labor market data from the 1950s, there has never been an example of the vacancy rate dropping dramatically without a significant increase in unemployment, they wrote.

“Combating inflation will require reducing vacancies and increasing unemployment,” they wrote. “There is no magic tool.”

In addition, the so-called natural unemployment rate – the rate at which economists believe unemployment begins to drive up inflation – is much higher than it was before the pandemic, they argued. They wrote that this means the labor market is narrower than many assume, and that the unemployment rate will need to rise much more than the Fed expects to bring down inflation.

Federal economist Andrew Figora and Governor Chris Waller Pushed back in a blog post Friday, saying a quiet landing is still possible. They recognized that “it would be unprecedented for job vacancies to decline by a significant amount without the economy falling into a recession”, but they said this was an unprecedented situation.

The problem is that the Fed does not have precise tools to target a specific vacancy rate or unemployment rate to slow the economy enough to lower inflation. And she doesn’t have a “slack” button she can press even if she wants to.

This raises the risk that the central bank will raise interest rates dramatically, causing painful deflation and potentially lowering inflation significantly, said economist Wendy Edelberg, director of the Hamilton Project at the Brookings Institution.

The biggest concern, she added, is that the economy is slowing and inflation remains high. That can happen if inflation expectations start to rise, or if supply shocks continue to hit the economy.

Claudia Sam, a former Fed economist, said a recession may still not be necessary if supply constraints begin to ease. “If we don’t solve the supply issues, we need to see consumers slow down their spending,” she said. “Growth should slow, business investment should slow. Things should get less hot.”

But in the end, what the Fed wants to see is lower inflation – and it’s up to Powell and his colleagues to decide how quickly they want it to happen.

“If they want 2 percent and they want it now, they can have it,” she said. “But then to get it, we’re going to need a slump.”