For months, investors around the world have been asking the same question: when will interest rates rise? With rates at historic lows, a sharp uptick in inflation has economists debating whether high prices will be short lived, or here to stay. On Wednesday, investors received a stark warning.

Speaking at the Citi Australia & New Zealand Investment Conference on Wednesday, former US Treasury Secretary Larry Summers sounded the alarm on rising inflation, saying inaction by the US Federal Reserve risks letting the situation get out of control.

He listed labour and goods shortages, rising house prices, and record petrol prices on top of some of the most ambitious fiscal and monetary policy outside of wartime as a challenge to continued dovishness of the US Federal Reserve.

He accused the Fed—which he was once tipped to lead—for being slow to act. Where it would once "remove the punchbowl" from an overheating economy, it's now spiking drinks.
"The party's gotten great and the Fed isn't removing the punchbowl until they're absolutely certain that everyone's going to get plastered," he says.

“When they start to see evidence… they’re saying people are going to drink a lot of coffee and drive home.”

Summers argues the recent rise in energy prices is making it more likely inflation will stick by shaking people's beliefs that prices will stay stable in the future. Consumers use petrol prices to gauge how prices are behaving, he says. If higher prices at the pump cause people to start expecting further rises, those beliefs can become self-fulfilling.

“I don’t think we’re in a terribly rational or sound place and I think we’re taking big risks,” he says.

The Fed has said its waiting for evidence the pandemic is firmly in the rear-view mirror before it removes stimulus. With 7.7 million still unemployed, it’s haunted by the years after the financial crisis, where policy makers in the US and Europe choked off the recovery by tightening too quickly.

Summers says the Fed may also be taking comfort from bond markets, which are still pricing in mild inflation. The 5-Year breakeven inflation rate, which measures expectations for average US inflation over the next five years, sat at 2.69% Thursday, close to the Fed’s 2% average inflation target.

But Summers, who first spoke out about rising inflation in February, says it's clear that shortages of workers and goods in the US are sending prices higher.

He’s found an ally of sorts in Atlanta Fed Bank President Raphael Bostic, who said Tuesday his staff would stop referring to inflation pressures as “transitory” because they could persist for some time. Bostic is a voting member on the Fed’s interest-rate setting Federal Open Market Committee.

Despite his long-time advocacy for more government spending, Summers blames much of the situation on excessive pandemic spending. For what he claims was a 2-3% shortfall in Gross Domestic Product (GDP), the US spend hit 15% of GDP.

“That’s a prescription for overheating,” he says.

An increasingly acrimonious debate over whether inflation is transitory or not has raged for months. Most central banks acknowledge higher prices but argue they will fade into 2022. Opponents say inflation will become self-sustaining and force central banks to rapidly hike rates to reign it in.

It’s the latter scenario that worries investors. Sudden and disorderly hikes in interest rates could trigger painful revaluations in equity markets, where they are used to price most stocks. Higher rates would also raise the cost of servicing debt in a world still digesting the pandemic borrowing binge. They could also hit growth just as signs are emerging it may be stuttering.

In its quarterly outlook released Tuesday, the International Monetary Fund slightly downgraded its growth forecast for the world to 5.9% from the 6% forecast in. It blamed the Delta-variant, supply chain disruptions and inflation concerns.

The most recent US Consumer Price Index showed prices rose across the board in September, climbing 0.4% after rising 0.3% in August. In the 12 months through September, the CPI increased 5.4%, higher than the 5.3% forecast by analysts.