By Howard Schneider
WASHINGTON, April 24 (Reuters) – Federal Reserve Chair nominee Kevin Warsh has called for a major rethink of how to measure inflation, but he may have less trouble finding new ideas at the central bank than in choosing from an expanding set of alternate models, measures and forecasts designed to understand how the price level is changing.
One month of recent data shows the dilemma.
February inflation numbers under the key measure tracked by the Fed came in nearly a percentage point above the central bank’s 2% target. Separate calculations at the Dallas Federal Reserve, using a methodology preferred by Warsh that discards outliers like the 384% annualized price jump for moving services or the 50% annualized crash for calculators and typewriters, suggested a close-to-target pace of just 2.3%.
The Cleveland Fed’s Center for Inflation Research, meanwhile, focused on the median pace of price increases and found it close to the Bureau of Economic Analysis’ headline number, while a more complex statistical model created by the New York Fed suggested underlying trend inflation was getting even worse at 3.1%.
The idea that a “true” measure of underlying inflation is at hand and so far overlooked by the Fed, said Omair Sharif, president and founder of Inflation Insights, “sounded like somebody who has not been in the building for a while and has not looked at inflation research since he left the Fed” in 2011 after a term as governor.
Sharif noted that the alternative measure Warsh said he favored at his Senate confirmation hearing on Tuesday, known as the trimmed mean, currently had the lowest inflation rate among the different common measurements – and was thus more compatible with the rate cuts expected by President Donald Trump — but also missed the broadening and acceleration of inflation in 2021, a key data lapse that more commonly used inflation statistics captured.
The trimmed mean measure maintained by the Dallas Fed, constructed by discarding items with outsized changes and averaging what remains, may be underestimating inflation in the current moment as well because of changes in the comparative “skew” between the fastest and slowest price changes.
The benefit of sticking with well-worn measures, like the personal consumption expenditures price index excluding food and energy, or core PCE, “is that it is better known in the market and possibly easier to explain with limited reference to statistics,” Krishna Guha, vice chair of Evercore ISI, wrote in an analysis of Warsh’s comments about developing a new Fed inflation framework.
While core PCE is considered the better guide to trend inflation, the Fed uses headline PCE for its 2% target. Warsh did not explicitly suggest changes to that target but did say focus should be “left of the decimal point,” hinting at a tolerance for inflation some degree above the goal.
BREAKING THE MOLD
Warsh’s hearing highlighted a number of areas he feels are ripe for reform, but his determination to fight what he called “the tyranny of the status quo” doesn’t mean that “a new framework, new tools, and…new communications” will be easily developed or successful.
The Fed can be hard to change, with its Washington-based Board of Governors, an influential team of board economists, 12 regional banks with their own staff and philosophies, and an array of former officials and staff often tapped to contribute to research or other debates. Current Chair Jerome Powell, for example, shares some of Warsh’s criticism of the Fed’s communications tools but was largely rebuffed by other policymakers and staff when he suggested changes last year.
But neither is thinking fixed. When many mainstream economists argued in 2022, for example, that fast Fed rate hikes risked massive unemployment, research by Governor Christopher Waller and staff economist Andrew Figura showed why that was unlikely, and helped ease policymakers’ concerns about raising rates to control inflation.
The Fed even ditched the “status quo” altogether in 2020 with a new framework that showed it could adopt new ideas, and also showed the risks of doing so. That new framework was abandoned just last year for having downplayed inflation at precisely the wrong moment and delaying policymakers’ response.
Much like the Powell Fed bet it could improve economic outcomes by lifting subpar inflation to test the limit of maximum employment with lower rates, Warsh is betting he can test the borders of non-inflationary economic growth with lower rates on the grounds that artificial intelligence will improve productivity and thus ease the pressure to raise prices.
‘VENEER OF CREDIBILITY’
In his hearing Warsh hedged on the timing, leaving his short-term rates outlook up in the air.
But the direction was clear. AI could “increase the potential output of the economy,” Warsh said in response to questions from lawmakers concerned that misreading its impact could mean a policy mistake and higher inflation. “We don’t know that. We can’t bank on that, but considerable work needs to be done by the Federal Reserve in evaluating this productivity wave.”
Current officials have said much the same: AI will change things, but at a pace and degree that is far from certain and hard to build into current policy.
On inflation, Warsh will find plenty of work in progress to find better measurements, and no shortage of opinion about the best ways to distinguish one-off price changes from the steady upward drift that economists classify as “inflation.”
Teasing out the broad and persistent from the narrow and “transitory” is a well-recognized problem. Fed officials during the pandemic surge of inflation came up with an array of ways to slice available data to find a signal, and delved into alternative “big data” sets of the sort Warsh mentioned in his hearing.
Indeed, Sharif said, government agencies have already incorporated more actual price data from private sources into the indexes they produce, and suggested that if Warsh wanted a quick path to better inflation statistics it would be convincing Congress to boost funding and staff for projects already under way at places like the Bureau of Labor Statistics.
“I think what he was going for was we need to understand the data collection for all types of prices. That is a laudable goal. It is what BLS has been doing for many years,” Sharif said. “But I don’t think you get to some big new trend you never thought of. What he should have said is what everyone says. We will look at a variety of things to get a handle on inflation.”
(Reporting by Howard Schneider; Editing by Dan Burns and Andrea Ricci )
