Fed Chairman Warsh faces inflation credibility test: analysis

For Kevin Warsh, reliability is everything. Congressional hearings this week revealed how difficult it will be for a new Federal Reserve chairman to maintain this.

Warsh had few, if any, major omissions amid intense questioning from Democrats and supportive comments from Republicans in consecutive days of testimony before the House and Senate on Tuesday and Wednesday. But both sides strongly agree that prices are still rising too quickly, and the Fed Chairman needs to quickly follow through on his promises to keep prices stable. If not, he risks losing support both within the Fed and the chairman’s traditional power base on Capitol Hill.

Part of Warsh’s challenge is that he wants to rethink how the Fed measures inflation. Two important measures of prices – the consumer and producer price indices – saw unexpected declines this week. CPI fell 0.4% in June, while PPI fell 0.3%.

“Any central bank would be happy to see data moving in the right direction,” Warsh said Wednesday. “My view is that these are all imperfect measures of the underlying inflation situation.”

The Iran war has raised gas prices in the US, but Warsh said that’s not necessarily inflation, or at least not the kind the Fed can deal with.

“Specific price shocks happen to particular prices that we don’t have control over. But I don’t want to suggest that we don’t have control over inflation in the medium term. That’s our job,” Warsh said.

Warsh has appointed a task force to help answer the question about the nature of inflation, but it will not produce results for months. The Fed will meet in two weeks to decide the direction of interest rates, and its voting officials appear divided on whether factors such as a surge in data-center construction to support the growing artificial intelligence industry are starting to drive up normalized prices.

Fed Governor lisa cook A speech on Wednesday pointed to AI spending as a potential driver of inflation. He warned of “significant price increases for chips, other high-tech equipment, software and utilities.” This is changing his overall view of inflation, he said, adding: “Inflation risks now outweigh employment risks.”

The debate over AI spending is “one of the good family feuds” at the Fed, Warsh said. His view was that supply is likely to increase in line with demand. “I don’t consider a change in prices necessarily inflationary because I think there’s a supply response. In that way, it’s different from a foreign conflict and what it can do, which is reduce the supply side of the economy.”

Whether a separate task force on AI will help resolve this debate remains to be seen. Some Republican senators praised the intellectual diversity of Warsh’s task force members, and the chairman spoke of his inclusion of one of them as a “team of rivals.”

But it is not certain that the task force will challenge Varsh’s views. All members of Worsh’s AI task force are extremely excited about AI. As Democratic senators pointed out Wednesday, there is no one in that group who will speak explicitly for labor.

Warsh is carrying on a conservative economic tradition at the Fed. His monetary policy report Congress revived the practice of reporting on the size of the money supply. The Fed, under former Chairman Jerome Powell, considered information about the money supply to be essentially irrelevant to inflation, but Wersch disagrees. He does not want to return to the era when the Fed targeted the size of the money supply in making policy decisions, but he believes that some monetary measures can provide useful information about inflation.

“I have this old-fashioned view that monetary policy has something to do with money,” Warsh said.

The risk for Warsh is that if inflation does not begin to decline in a tangible way soon, all these decisions will be closely scrutinized for signs that ideology has trumped clear analysis. Wersch has avoided making any commitments on where he will take interest rates, but the market now expects the Fed to raise interest rates by the end of the year. Warsh needs to get on the right side of that decision.

If the rates go up because Warsh loses an argument about AI spending in front of other members of his committee, the chairman’s credibility will suffer. An even worse outcome would be that Warsh won the debate and kept rates stable or down, but inflation rose again.

This kind of loss of credibility would be a problem that even the best task force could not fix.