COVER STORY
Larry Summers predicted the Federal Reserve would need to keep unemployment and interest rates above 5 % for several years to expunge inflation . So far he has been dead wrong .
like former U . S . Treasury Secretary Larry Summers predicted the Federal Reserve would need to keep interest rates and unemployment above 5 % for several years to expunge inflation . The mere presumption that the central bank could control the labor market to that degree showed how much weight policymakers like Summers attach to its powers . But so far he has been dead wrong .
If , as many believe , the Fed officially finished its current stint of rate increases last July , that would mean the current unemployment rate , 3.9 %, would be the lowest it ’ s been six months out than it was in the previous six hiking cycles , according to Invesco ’ s Hooper . Still , that debate over when and how frequently the Fed will cut interest rates this year remains contentious .
What happens beyond this year , in the next decade , will be more important for advisors and clients . Ed Yardeni of Yardeni Research has outlined some basic scenarios , looking in the rearview mirror 50 and 100 years back to describe the current era .
The first scenario he calls the “ Roaring Twenties .” Here , “ our basic premise is that a chronic shortage of labor is forcing companies to use technological innovations to boost their productivity growth , which started to improve last year , according to the government ’ s quarterly data ,” Yardeni wrote in a client email on January 21 . “ As a result , inflation remains subdued in this scenario , while real GDP growth , real wage growth , and profit margins all get boosted .” He says there ’ s a 60 % probability of this scenario coming to pass .
There ’ s a 20 % chance of the second scenario . He dubs this one “ the 1970s ,” since several economists have compared that period to the last couple of years when inflation returned . Even though price increases slowed in 2023 , he writes , “ there is still a risk of a second inflationary energy shock as occurred during the 1970s .” This one , however , would be tied to geopolitical problems , including “ Russia ’ s invasion of Ukraine in early 2022 . If the conflicts in the Middle East continue to spin out of control , oil prices could soar again .”
In the ’ 70s scenario , “ the Fed is forced to raise interest rates … and cause a recession ,” an outcome that was quite believable a year ago . Equities in this situation would likely perform dismally . However , inflation indeed began to wane early last year , and the advent of AI has re-energized the stock market . Most important , the economy accelerated in
2003 ’ s second half .
In the January 21 email , Yardeni outlined a third scenario : a 1990s-style stock market bubble exacerbated by Fed policy ( this , too , won a 20 % chance of happening ). In this worrisome case , the Fed grows “ concerned that inflation is falling below 2.0 % and responds by aggressively cutting interest rates , even though the economy continues to perform well .”
That could spur a “ melt-up ” in the stock market , a surge led by technology stocks . “ The resulting valuation bubble bursts when the Fed is forced to raise interest rates , because asset inflation shows signs of precipitating another round of price inflation ,” Yardeni concludes .
His stock market target is for the S & P 500 to finish this year at 5,400 , so one can only imagine how far a melt-up might take equities .
Debt Catches Up
Voices of dissent say the central bank is likely to remain more hawkish than the prevailing view suggests , and view as unrealistic the notion that the Fed would cut rates four to six times in 2024 . Macro
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