Fed sees inflation mistakes justified after COVID-19, says Larry Summers

Larry Summers believes the Federal Reserve is right after its first misstep on inflation.

The former Treasury secretary told Bloomberg TV that the central bank's interest rate strategy had been largely successful, even though Fed officials made a major mistake by initially underestimating inflation during the pandemic.

In 2021, the Fed incorrectly described inflation as “transitory,” arguing that COVID-related supply chain disruptions would eventually pass.

Instead, the consumer price index rose to over 9% the following year.

“The miscalculation was pretty stark,” Summers said, pointing out that the Fed expected to keep interest rates at zero until 2024: “That was a low point in terms of monetary policy judgment.”

When central bankers realized that inflation required an interest rate response, the Fed launched the most aggressive tightening campaign in recent history. Since March 2022, the benchmark interest rate has risen from near zero to 5.25 to 5.50 percent.

During this period, Summers often expressed skepticism that the Fed could control inflation in this way without economic consequences. Higher interest rates slow price growth but carry the risk of unemployment and an economic downturn.

Summers estimated there was a 75 percent chance of a recession in the U.S. by August 2022, but acknowledged that the likelihood of inflation abating without a significant deterioration in employment was lower.

Two years later, his alternative prediction seems more accurate.

“I have to give the Fed credit for responding, while it has not always been obvious, strongly and forcefully enough to maintain expectations,” Summers told Bloomberg, adding that a recession appears increasingly unlikely.

“Consequently, I think the growth and employment statistics of this period will be remembered as quite good.”

His comments come shortly after Fed Chairman Jerome Powell's speech at the Jackson Hole Symposium. In a highly anticipated speech, Powell signaled that the time had come for an adjustment in monetary policy.

The main question now is how far rates could fall during the Fed's September meeting. Given the weakening labor market data in July, most believe a cut of at least 25 basis points would be appropriate.

This could also be influenced by future labor market data. If, for example, unemployment or non-farm payroll numbers worsen, even deeper cuts could make sense, analysts say.