Former Treasury Secretary Larry Summers said unemployment in the U.S. Would need to rise significantly for an extended period of time if it has any chance of curbing the inflation that is wreaking havoc on global markets.
“We need five years of unemployment above 5% to contain inflation—in other words, we need two years of 7.5% unemployment or five years of 6% unemployment or one year of 10% unemployment,” Summers said in a speech in London on Monday, Bloomberg reported.
“There are numbers that are remarkably discouraging relative to the Fed Reserve view,” he added.
Unemployment in the U.S. Currently sits at 3.6% after U.S. Employers added 390,000 jobs in May, according to the Bureau of Labor Statistics monthly jobs report released in early June.
Inflation historically has an inverse relationship with unemployment, meaning when inflation is high, unemployment is typically low. In basic macroeconomic principle and in the opinion of Larry Summers’, higher unemployment would translate to people having less discretionary income to purchase goods, lowering demand and reducing prices—i.e. Inflation.
“The gap between 7.5% unemployment for two years and 4.1% unemployment for one year is immense,” said Summers, adding, “Is our central bank prepared to do what is necessary to stabilize inflation if something like what I’ve estimated is necessary?”
Embodying Volcker’s legacy
One danger is that unemployment and inflation will fall out of their usual inverse relationship and leave the U.S. Economy in a period of high unemployment and high inflation—or stagflation, a term that has seen spiking Google interest over the past month.
The last time the U.S. Saw a period of stagflation was in 1973 after the collapse of the Bretton Woods currency system, which left the U.S. Dollar in free float. In the face of surging high inflation, Fed chief Paul Volcker famously brought the fed funds rate—which currently sits between 1.50% and 1.75%—to above 20%, bringing on back-to-back recessions in 1981 and 1982, and record-high unemployment, but also bringing inflation back down to manageable levels.
Summers says the same drastic action may need to be taken again.
“The U.S. May need as severe monetary tightening as Paul Volcker pushed through in the late 1970s, early 1980s,” Summers said.
Summers suggested that the Fed should be cautious over how much it communicates with the public about how it plans to proceed with monetary policy tightening.
“The return to humility, the abandonment of forward guidance as a policy tool, is entirely appropriate,” Summers said. “It is likely to be necessary to make much more difficult choices than yet contemplated between acceptance of slack and acceptance of sustained, above-target inflation.”
“In that way, I fear we are going to have both elements of secular stagnation and secular stagflation,” he said.
The Fed increased interest rates last week by 75 basis points, the biggest increase since 1994, and signaled it sees another large rate hike coming at the July Federal Open Market Committee (FOMC) meeting—in the 50- or even 75-basis-point range.
The Fed said on Friday that it would do whatever it takes to get prices under control, saying its commitment to reining inflation is “unconditional,” and reiterated that stability is necessary to support a strong labor market.
