Markets may be wrongfooted by future US rate rises, warns Larry Summers

Former US treasury secretary Larry Summers suggested on Friday that financial markets may be underestimating how much further the US Federal Reserve will go with rate hikes as it continues to seek to rein in inflation, even as recent data shows that headline consumer prices growth has started to decline.

“I can see many, many more scenarios in which rates end up higher than currently priced [by the market] than I can see rates lower than priced,” said Mr Summers, now a professor at the Harvard Kennedy School of Government, on a panel on the final day of the World Economic Forum in Davos. “Therefore, I am a bit surprised by the market’s forecast of what is happening.”

Financial markets expect the Fed to increase its main rate by 0.25 of a percentage point in its February and March meetings, but that this could be the end of the US central bank’s cycle of rate hikes.

The Fed raised its benchmark overnight interest rate by 4.25 percentage points to a range of 4.25-4.5 per cent last year, with the bulk of its most aggressive pace of tightening in four decades coming in 0.5- and 0.75-point moves.

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US inflation fell in December to an annual rate of 6.5 per cent, marking a sixth straight month of decline to the lowest level in more than a year, from 7.1 per cent in November, the US Labor Department said last week, prompting US president Joe Biden to cheer the report as indicating that prices were “clearly moving in the right direction”.

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Mr Summers, who served as the country’s treasury secretary between 1999 and 2001 and, later, as director of the US National Economic Council from 2009 to 2010, warned that any moves to change in the 2 per cent inflation target of most major central banks, including the Fed, the European Central Bank and Bank of England, “would be a grave error”. The topic of raising inflation targets has been one of much discussion among economists in recent times.

“It seems to me that [major central banks] having failed to attain the 2 per cent inflation target and having re-emphasised repeatedly the absolute commitment to 2 per cent, to then abandon the 2 per cent inflation target would do very substantial damage to credibility,” he said. “If you can adjust, you can adjust again.”

Mr Summers said that “much of the rhetoric” among certain commentators about how central banks should not move so aggressively at increasing interest rates for fear of pushing the economy into recession misses a key point.

“The counterfactual is, if we fail to deal with inflation, we are likely to have a much larger and more serious recession at some subsequent point,” he said.

Speaking on a subsequent panel, Mr Summers said: “The greatest tragedy in this moment would be if central banks were to lurch away from a focus from assuring price stability prematurely and we were to have to fight this battle twice.”