[Q&A] Summers: "US Fiscal Situation Serious... Likely to Lead to Prolonged High Interest Rates" (Comprehensive)

Lee Chang-yong, BOK Governor, Virtual Talk
"Geopolitical Risks Highest in 40 Years...Central Banks Must Prepare for Extreme Scenarios"
"Uncertainty in China's Growth Drivers...Economic Growth Rate Expected to Slow"

Lawrence Summers, former U.S. Treasury Secretary and Harvard University professor, stated on the 6th that “the U.S. fiscal (deficit) situation is more severe than generally accepted, and this is likely to lead to prolonged high interest rates.”

Professor Summers held a YouTube video dialogue at the Seoul Forum co-hosted by the World Bank (WB) and the Bank of Korea (BOK) at the BOK Conference Hall with Lee Chang-yong, Governor of the Bank of Korea. He said, “The U.S. fiscal deficit could act as a driving force leading to higher interest rates.” Last month, Summers also criticized the size of the fiscal deficit, which stands at about $1.7 trillion, at an event hosted by the think tank Center for American Progress.

Summers predicted that the U.S. Federal Reserve (Fed) would maintain its benchmark interest rate freeze in December but still saw the need for one more rate hike. He pointed out that the Fed’s perception that the current monetary policy is sufficiently tight and that rising long-term interest rates reduce the need for short-term rate hikes is an “overconfidence,” adding, “The market’s view that tightening is over is exaggerated.”

Regarding current geopolitical risks such as the Middle East war, he suggested that the situation is precarious and emphasized, “Central banks should prepare for extreme situations by diversifying supply chains and maintaining flexibility in monetary or fiscal policy.”

On the outlook for the Chinese economy, he predicted a slowdown in growth. He said, “Currently, high-income groups in China are trying to move money abroad, and the birth rate has dropped by about half over the past six years. With uncertain growth drivers, the Chinese economy is likely to grow more slowly than in recent years.”

[Image source=Yonhap News]

The following is a Q&A between Governor Lee and Professor Summers.

- Did the Fed’s November decision meet expectations? Do you see a possibility of one more rate hike in December? What is your outlook on U.S. inflation and the possibility of a soft landing?

▲ The Fed gave clear signals at the last meeting that it would not move, so it was not surprising at all. If I were in the Fed’s position, considering the current uncertainties, I would also have refrained from moving. I expect the Fed to hold rates steady in December as well. However, given the economy’s considerable resilience and persistent inflationary pressures, there is a need for one more rate hike. This is not a view I hold with strong conviction.

The U.S. fiscal situation may be more serious than many people realize. Over time, this could become a driving force leading to higher interest rates. The Fed seems confident in two judgments: one is that the current monetary policy is very tight. While I do not know the neutral real interest rate or inflation outlook at this moment, I am not convinced that the current monetary policy is sufficiently tight.

The other judgment the Fed is confident about is that the rise in long-term interest rates reduces the need to raise short-term rates. However, the rise in long-term rates may reflect expectations of increased demand due to government debt expansion or higher investment demand, so lowering short-term rates may not be an appropriate response. I think the market’s view that the Fed’s tightening is over is somewhat exaggerated.

- Do you expect the recent rise in U.S. medium- to long-term interest rates to continue?

▲ I believe the neutral real interest rate is currently around 1.5?2%. I expect the inflation rate to average between 2% and 2.5% over the next few years. Also, I anticipate the term premium to rise by 100?150 basis points. Adding these together, the 10-year Treasury yield is expected to be in the 5% range or slightly higher. This implies a neutral nominal rate in the 4% range. So, interest rates could eventually fall from current levels. However, the market consensus on how much they will fall seems lower than my view.

- The pressure of low growth due to population aging is a bigger issue for Korea than for the U.S. You predicted that neutral rates would trend downward after the recent high inflation period. If U.S. neutral rates have spillover effects on Korea, how should we revise our view on Korea’s neutral rate? There is considerable concern about how to conduct monetary policy in an open economy.

▲ Generally, demographic changes are an important factor in neutral interest rates. If Korea is a chronic trade surplus country in the medium term, it would have an effect similar to raising the neutral rate. Therefore, analyzing Korea’s neutral rate purely on a domestic basis could be somewhat mistaken. I believe Korea’s neutral rate tends to follow the global neutral rate. The rise in long-term interest rates observed in the U.S. reflects a growing market perception that the global neutral rate is higher. Thus, it is necessary to distinguish between the Fed’s influence on long-term rates and the real economic conditions affecting the Fed’s actions. The Fed is likely to respond more quickly.

- Geopolitical risks are increasing. What is your assessment of the current geopolitical risk developments and their potential impact on the global economy?

▲ I think we are at the most geopolitically dangerous conflict point in the past 40 years. Considering the Middle East situation, the Russia-Ukraine war, Korean Peninsula risks, U.S.-China tensions, and China-Russia-Iran relations, it is very dangerous. It is so concerning that I want to check the news before going to bed. Central banks, foreign exchange reserve managers, and investors should conduct stress tests on the real market movements. In this context, we must prepare for the possibility of very extreme outcomes. This can be done by diversifying supply chains and maintaining flexibility in monetary or fiscal policy. However, when making policy decisions or investment activities, I believe it is better to focus more on positive trends rather than overly negative individual events.

- How do you view the Chinese economy?

▲ What China has achieved over the past 45 years is unprecedented in human history. However, recent indicators are quite concerning. Watching emerging markets for years, the best predictor of a country’s medium-term outlook is what the wealthiest people in that society do with their money. If they move money into the country, it is a positive sign; if they move it abroad, it is a negative signal. Recently, there appears to be strong pressure among China’s wealthy to move money overseas. Also, the birth rate has dropped by nearly half over the past six years, which is a clear indicator. This likely reflects perceptions about China’s future society.

China initially grew through exports, then infrastructure investment, and then real estate investment. With these growth drivers exhausted, the next growth driver is unclear. Therefore, I think China’s growth over the next few years will be considerably slower than in recent years.

- At the recent G20 meeting in Marrakesh, you emphasized the need to expand World Bank resources. Why is that?

▲ The world is on fire. Considering climate change and vulnerable countries, the expected annual damage for the next generation will probably be about one-seventh to one-sixth of that during COVID-19. Under these projections, many major development challenges remain, which are more pressing than the debt levels of developing countries. Therefore, we believe the multilateral development bank (MDB) system needs both quantitative and qualitative strengthening over the next few years. The appropriate level of lending by 2030 is expected to be about three times the current level, which we call the “tripling agenda.” We believe we must increasingly support global public goods and strengthen cooperation with the private sector.

- I watched your recent dialogue with Professor Angus Deaton of Princeton University with great interest. It seemed that our society is moving more toward emphasizing equality and fairness rather than efficiency. Whether right or wrong, this has imposed many constraints on our policy decisions, especially during the pandemic. Many countries relied on economically populist policies such as lump-sum payments. It is very difficult to revert to policies emphasizing efficiency. What guidance would you give to policymakers worldwide on how to cope?

▲ Human development indices such as literacy, child mortality, and life expectancy roughly correspond to a country’s GDP level. Generally, almost all high-income countries perform much better in human development than low-income countries. However, what is truly important for humanity’s future is whether more countries can enjoy the remarkable changes Korea has achieved since 1960. The issues of equality and fairness are indeed important, but Professor Deaton seems to have overlooked the fact that a faster escalator is much better than a slower one in reaching life’s destinations. This is a very important point that we, as macroeconomists, should all keep in mind.

I will return to the issue of foreign exchange reserve management. Short-term government bonds generally have the lowest yields. If liquidity is needed, securing liquidity is absolutely the right thing to do, but if not, one should consider ways to gain profits through long-term investments. I believe this is a matter that several countries with substantial asset accumulation should discuss.

This content was produced with the assistance of AI translation services.