(Bloomberg) — Former Treasury Secretary Lawrence Summers has warned that the bond market’s long-held assumption that an era of low interest rates — anchored by mitigating pressures of inflation — may be wrong.
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“I suspect there will be turmoil” for markets in 2023, Summers told Bloomberg TV’s “Wall Street Week” with David Westen. “We will remember this as the ‘fifth’ year when we realized we were heading into a different kind of financial era, with different kinds of interest rate patterns.”
Summers said a range of indicators in the bond market, as well as the longer-term outlook from the Federal Reserve, point to broad expectations of the same drivers that kept inflation ahead of its recent rally. Quote:
Ten-year Treasury yields, which have averaged about 3.7% in the past three weeks. This equates to an average of 3.89% over the past three decades.
The Fed’s average forecast for the long-term real federal funds rate is 0.5% – reflecting expectations of 2% for inflation and a policy rate of 2.5%.
The US 10-year breakeven rate, a measure of long-term inflation expectations derived from the spread between the yields on the ordinary 10-year Treasury note and those of the inflation-linked 10-year note, is just over 2%.
These assumptions are likely to be wrong, Summers said — “just as those who, during World War II, predicted that when the war was over we would go back to secular stagnation, a sluggish economy, and a low rate of interest, could be wrong.”
Summers, a Harvard professor and paid contributor to Bloomberg Television, highlighted a number of shifts that suggest the pre-Covid pattern of secular stagnation will not return.
The fiscal deficit and government debt burden are likely to swell on an ongoing basis, thanks in part to increased spending on national security. Investment expenditures are also likely to be stronger, with efforts to bring production back to the United States and greater flexibility in supply chains. According to Summers, the “Global Green Energy Transition” will also help chip away at savings.
Meanwhile, he said, the dynamism of workers from China and other emerging markets joining the global economy – working to lower price pressures – has now run its course. In addition to increases in uncertainty, he added, investors are likely to demand higher premiums for taking on the risk.
Former IMF chief economist Olivier Blanchard made a contrarian argument, seeing reasons why three major drivers of low rates are likely to remain in place in the future. Demographic trends mean that savings rates are likely to remain high, and there may still be strong demand for the relative safety of government securities, he argues.
While a big wave of spending on green technology to combat global warming could raise rates, Blanchard, a senior fellow at the Peterson Institute for International Economics, still concludes that they will remain “fairly low.”
Read more: We can’t completely escape the world of low prices
Summers agreed that these forces of secular stagnation were “strong” and that this scenario might end up playing out, but ultimately ruled that such “orthodoxy” would prove untrue.
Turning to the US jobs report for December, the former Treasury secretary said the evidence of slowing wage gains was “encouraging,” and the strength of the employment expansion adds to the evidence that the timing of the US recession has been delayed.
Read more: US employment is strong while wages are cool, giving the Fed room to slow gains
“But I think the judgment that a soft landing is a triumph of hope over experience is still the right best guess,” he said. “I’m not sure that sustained power indicates a softer landing, rather than a harder landing when the balance is rebalanced.”
Summers reiterated his praise for the hawkish turn Fed policymakers have taken over the past several months. He also reiterated that the central bank should follow its signals to raise interest rates further and keep interest rates high for some time to suppress inflation.
(Updates with an alternate perspective starting in the fourth paragraph after the chart, along with Summers’ other notes.)
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