The Fed has redeemed itself after an ‘egregious’ post-COVID inflation error, former Treasury Secretary Larry Summers says

Former Treasury Secretary Larry Summers

Larry Summers considers the Federal Reserve vindicated after its initial misstep on inflation.

The former Treasury Secretary told Bloomberg TV that the central bank’s interest rate strategy has largely succeeded, even though Fed officials made a major blunder by first underestimating pandemic-era inflation.

In 2021, the Fed mischaracterized inflation as “transitory,” citing that COVID supply chain disruptions would eventually blow away.

Instead, the consumer price index climbed to more than 9% the next year.

“The misjudgment was a pretty egregious one,” Summers said, citing how the Fed expected for interest rates to remain at zero until 2024: “That was a low point in terms of monetary policy judgement.”

Once central bankers grew to understand that inflation needed an interest rate response, the Fed initiated the most aggressive policy-tightening campaign in recent history. Since March 2022, the Fed funds rate has climbed from near-zero levels to 5.25%-5.50%.

In that period, Summers often showcased skepticism that the Fed could clamp down on inflation this way without economic consequences. Though higher rates slow down price growth, they risk joblessness and an economic downturn.

By August 2022, Summers was pricing in a 75% chance of a US recession, though he also acknowledged smaller odds that inflation fades away without a meaningful deterioration in employment.

Two years later, his alternative forecast appears more true.

“I’ve got to give it Fed credit for the fact that, while it wasn’t always obvious that this would be the case, they moved strongly enough and vigorously enough to keep expectations anchored,” Summers told Bloomberg, adding that a recession looks increasingly unlikely.

“As a consequence, I think if you look at the growth statistics or the employment statistics through this period, they will be remembered as having been quite good.”

His comments come shortly after Fed Chairman Jerome Powell spoke at the Jackson Hole Symposium. In a widely-anticipated speech, Powell signaled that the time has come for monetary policy to adjust.

Now, the main question is how far interest rates could fall during the Fed’s September meeting. Given cooling labor data in July, most feel that at least a 25-basis point cut is appropriate.

Future jobs prints could sway this. For instance, if unemployment or nonfarm payroll data worsens, analysts have argued that a deeper cut could be worthwhile.