By Naveen Athrappully
Former Treasury secretary Lawrence Summers sees a “real risk” of stagflation in the U.S. economy and believes the Federal Reserve committed a mistake by not recognizing inflation earlier on.
In an April 20 podcast with journalist Kara Swisher, Summers was asked about economist Mohamed El-Erian’s warning that the crisis triggered by the collapse of Silicon Valley Bank (SVB) could result in cautious lending from banks and eventually stagflation—referring to an economic cycle characterized by slow growth, high unemployment, and inflation.
“I think it’s a real risk,” Summers replied. “Given where inflation is right now and given the downward pressures on the economy, I certainly think stagflation is a meaningful risk right now, and it’s probably a risk that’s underpriced in the markets.”
Regarding inflation, Summers insists that the Federal Reserve made a “big mistake” in not recognizing the threat of inflation back in 2021. The Fed remained stuck with that error “for much too long.” The central bank then “compounded that error” by not acting on the SVB crisis “soon enough,” allowing it to become a “broad systemic problem.”
Both inflation and SVB are two big problems “that got missed.” If the Fed had dealt with inflation earlier on, there wouldn’t have been a “dramatic spike” in interest rates that eventually led to the difficulties faced at SVB, he said.
Summers is unsure how high the Fed will have to raise interest rates to tame inflation and for how long it will have to keep rates at that elevated level. However, Summers thinks the economy is a “large part of the way through” the necessary tightening.
“If there were not a credit crunch and a banking set of issues, I would feel that the Fed needed to engage in three, perhaps a little more than that, more tightenings” he said.
“Given that we have this credit crunch coming from the banking side that’s doing some of the work of interest-rate increases, it’s possible that we’ll have had enough after May.”
In an April 10 article in Financial Times, El-Erian predicted that the odds of a recession and stagflation afflicting the U.S. economy are now higher following a series of bank collapses in March.
“The flashing red light resulting from a speed-of-light run on the U.S. banking system, or what economists broadly refer to as financial contagion, is behind us,” he wrote. However, the banking system will now be more cautious to issue credit due to the recent collapses.
At the same time, many Americans have moved money away from bank deposits into market funds that offer higher yields.
“Instead, red has become a flashing yellow due to the slower-moving economic contagion whose main transmission channel, that of curtailed credit extension to the economy, increases the risk not just of recession but also of stagflation.”
In a March 29 report, Morgan Stanley advised investors to “brace” for stagflation. The turmoil in the banking system raises the risks of recession, untamed inflation, and higher unemployment. Concerns about financial stability could force the Federal Reserve to “prematurely” stop its fight against inflation.
“Price pressures remain relatively high, with the core Consumer Price Index (CPI) rising 5.5 percent year over year in February and services inflation still accelerating,” according to the investment bank.
“The risk is that inflation stays higher for longer, even as the economy slows—a recipe for stagflation that would likely see consumers suffer a decline in spending power once their incomes are adjusted for inflation.”
The Federal Open Market Committee’s (FOMC) minutes from the March policy meeting state that staff at the central bank are expecting a “mild recession” later this year following the fallout of the banking turmoil. A recovery is predicted to take two years.
The Conference Board’s Leading Economic Index (LEI) fell to its lowest level since November 2020 in March.
“The Conference Board forecasts that economic weakness will intensify and spread more widely throughout the U.S. economy over the coming months, leading to a recession starting in mid-2023,” said Justyna Zabinska-La Monica, senior manager, Business Cycle Indicators at The Conference Board.
In a recent interview on the Fullsend podcast, former president Donald Trump criticized the policy of high interest rates and warned that the United States will see a “big recession very soon.”