Larry Summers says the Fed is ‘considerably too optimistic’ and risks surprises from fast inflation, weak growth—or both

Former Treasury Secretary Lawrence Summers said Federal Reserve policymakers are too optimistic with their latest set of economic projections, cautioning that they are at risk of being surprised by both faster inflation and weaker growth than they anticipate.

“The Fed is considerably too optimistic,” Summers said on Bloomberg Television’s Wall Street Week with David Westin. “It’s more likely than not that they’re either going to get surprised on the higher-inflation side, or on the weak” growth side, “or possibly both could materialize — in a stagflationary kind of dynamic,” he said.

Fed policymakers boosted their forecasts for economic growth this year and next in their latest projections on Wednesday. They also cut their estimate for core inflation, which strips out food and energy costs, for this year, and see it at 2.6% by the end of 2024 — not far from the 2% target.

While Fed Chair Jerome Powell said in his press briefing that a soft landing isn’t his baseline expectation and that he “wouldn’t want to handicap the likelihood of it.” He also played down the importance of the median forecasts of policymakers. After keeping interest rates unchanged Wednesday, the Fed will “proceed carefully” going forward, he said.

Summers, a Harvard University professor and paid contributor to Bloomberg TV, applauded Powell for abandoning “forward guidance” and being prepared to respond flexibly to data and the outlook as they evolve. Still, the Fed moved “too slowly” away from telegraphing its upcoming moves, he said.

Fed officials penciled in one more rate hike by year-end in their updated projections, with two reductions seen in 2024. Summers said “there’s probably more risk that they’re going to need to move rates upwards more than they’re now projecting, but the risk is very much a two-sided one.”

Economists have for months been postponing or abandoning their calls for a US recession, with price and wage gains decelerating alongside resilience in economic growth. Goldman Sachs Group Inc. early this month said it now sees a 15% chance of a downturn.

“People are just a little too optimistic right now, and I think the Fed’s caught into that optimism,” Summers said. “It’s a good idea to under-forecast and over-perform.”

The former Treasury chief listed a range of risks the economy faces:

  • The United Auto Workers union’s strike against carmakers.
  • A fiscal deficit approaching 8% of gross domestic product after adjusting for student-loan accounting.
  • Health insurance costs that are poised to climb, pressuring inflation.
  • Signs of slower consumer spending since Labor Day, amid a rise in loan delinquencies.
  • A re-setting of borrowing costs higher as corporate loans and bonds roll over.

Summers highlighted the importance of the push over the past year or so by organized labor to secure significant compensation gains in the auto and other industries.

“A lot about what’s happened in the economy over the last several decades can be explained by changes in labor power,” Summers said. When then-President Ronald Reagan in 1981 fired air-traffic controllers striking for higher wages, that had a “very large effect” on the psychology of engagement between workers and employers, he said.

Now, with the recent “highly publicized labor conflicts” and the potential for a large wage-hike settlement, “that’s going to give a lot of workers in a lot of places some pretty big ideas.”

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“We need to be alive to the possibility that these various union developments are going to represent a bit of a substantial change that will have impacts on the way the economy functions for quite some time to come,” Summers said, adding that he didn’t outright predict that outcome.

The labor push may be a source of wage pressure that “complicates the issues around inflation,” he said.