In a recent piece WSJElizabeth Warren criticizes Larry Summers’ views:
Despite these warnings, the Fed chairman still has cheerleaders for his rate-hiking approach. Chief among them is Larry Summers. “We need five years of unemployment above 5% to prevent inflation – in other words, we need two years of 7.5% unemployment or five years of 6% unemployment or one year of 10% unemployment,” the former Treasury secretary said recently in London. School of Economics. You read that right: 10% unemployment. This is the comment of someone who has never worried about where his next paycheck is coming from.
My view is closer to Summers than to Warren. Still, I’m a bit surprised by his unemployment estimate. If they are based on a “Phillips curve” type model, then I would look at the assumptions with a lot of caution.
It is true that unemployment often rises during periods when the rate of inflation is reduced. But high unemployment is not directly caused by low inflation (that would be due to a price change.) It depends why Inflation rate has come down.
The real problem is not low inflation; High unemployment is more closely associated with lower NGDP growth, or lower wage inflation, or lower inflation expectations.
Although the US CPI inflation rate recently reached 9.1%, (5-year) expected inflation rates are relatively low – mostly in the 2.5% to 3.5% range. And the PCE index targeted by the Fed ran about 25 basis points lower on average. On the contrary, even expected By the late 1970s inflation had reached nearly double-digit levels. Thus it should be much less expensive to reduce inflation today than it was in the 1980s.
Wage inflation is also running high (about 6%), but nowhere near as bad as CPI inflation or as bad as wage inflation in the 1970s.
if you look Fed funds futures market, investors expect short-term rates to rise to 3.4% through the monsoon, and then fall slightly below 3% by the end of 2023. This type of yield curve inversion often precedes a recession, but it also indicates that investors expect the recession to be relatively mild. If unemployment is expected to average 7.5% over two years, interest rates will drop to near zero by the end of 2023.
Of course those are just market predictions; The reality turned out almost exactly as expected. So a major recession is possible. But at the moment, investors seem to be pricing in a fairly mild recession, perhaps with inflation expectations not reaching late 1970s levels. In fact, after 8 years of Paul Volcker’s monetary restraint, inflation expectations are below the levels of the late 1980s.
All policy failures are relative.
Rest assured. If I see one more reporter say that two quarters of GDP decline is a “technical recession” I’ll shoot myself. The US labor market rose in the first two quarters of this year. The correct view is that, as a rule of thumb, a two-quarter fall in GDP is usually accompanied by a recession.