The U.S. Economy has surprised economists, investors and the Federal Reserve in recent months, showing a lot more resilience than many people expected during record-high inflation rates and equally aggressive interest rate hikes.
The Fed has increased interest rates eight times since last March to calm soaring prices, and it has worked to some degree. Inflation was down 6.5% in December from a 40-year high of 9.1% in June. But with unemployment at a 50-year low, and a huge number of jobs created in January, there are still signs that the economy is hot and the Fed’s 2% inflation target may take longer to achieve.
To former Treasury Secretary and Harvard economics professor Larry Summers, the mix of optimistic economic data with an ongoing interest rate battle has made the economy hard to read. And on Thursday, he said he was concerned that the Fed would stop fighting the inflation “infection” before it had healed it.
“We’ve all had the experience of taking a course of drugs and giving up, stopping the drugs before the course was exhausted but simply because we felt better. And then, whatever infection we had came back, and it was harder to fight the second time,” Summers said Wednesday in an episode of the Here & Now podcast.
“The hard thing to judge is whether inflation is on a strong enough downward trajectory to get to the 2% target, and whether, if inflation comes down, it will stay down,” he added. “It’s going to be a very difficult balancing act [for the Fed].”
Summers said he does think the economy will ultimately slow and inflation will drop—but that brings a whole new set of problems.
“I still think the risks are very large that we either don’t get inflation down durably, or that at some point in the process, the economy tips into recession,” Summers said.
He adds that a confluence of factors including consumers running out of their savings from generous COVID-19 stimulus (which Summers was a vocal critic of) as well as corporate layoffs and hiring freezes could force the economy to slow down too much in 2023.
Despite worries about a downturn, though, Summers said he thinks the economy could still manage a “soft-landing,” in which inflation comes down without a recession.
Economists have been debating for months about the likelihood of a recession versus a soft-landing. Mohamed El-Erian, a leading economist and the president of Queens’ College at the University of Cambridge, has argued that the meaning of a “soft landing” is changing because the comfortable inflation rate for the economy may be higher than 2%.
And Nobel prize-winning economist Paul Krugman, who initially argued that the COVID-19-associated inflation was transitory, has changed his stance, and has said that prices will cool eventually. But he says the Fed should keep their policies as flexible as possible, given that the economy can move in any direction.
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