If a preliminary deal to end the war with Iran holds, the worst of the inflation surge that has followed in its wake could soon be over. Oil prices have dropped significantly since the announcement of a truce this month. Gasoline costs have, in turn, begun to fall, and airfares and shipping fees are poised to follow.
But despite this reprieve, the U.S. inflation problem is far from fixed. Measures of underlying inflation were already showing little progress before the war began several months ago. The trend has only worsened as the fighting and other forces, like the boom in artificial intelligence, have stoked prices.
On Thursday, data from the Commerce Department is expected to show that the Federal Reserve’s preferred inflation gauge, the Personal Consumption Expenditures price index, accelerated again in May. Overall prices are forecast to have jumped 0.5 percent during the month, or 4.1 percent from a year earlier. Once food and energy prices are stripped out, “core” inflation is expected to notch a 3.4 percent annual pace, a fresh high since 2023.
It is possible that, if the war with Iran has indeed ended, May or June data will mark the peak of the recent run-up in inflation, said Alan Detmeister, who worked at the Fed before joining UBS. The impact of President Trump’s tariffs on prices has finally begun to fade. Housing-related inflation has firmed in recent months but is expected to resume decelerating over time. Wage growth has stayed muted despite the recent stabilization of the labor market. And higher productivity from the proliferation of A.I., if sustained, could eventually help tame prices.
Yet even if these forecasts pan out, Mr. Detmeister reckoned, it will take two more years for the Fed to reach its 2 percent target, having already overshot it for half a decade. The risks to inflation, he added, are also all pointing up.
The question that Fed officials are now grappling with is just how patient they can afford to be in waiting for underlying price pressures to ease. How that is best measured is also up for debate. The issue has come to define the divisions dominating the central bank as it weighs the need to raise rates to make good on a pledge to deliver price stability — something Kevin M. Warsh, the new chairman, has repeatedly vowed to do. He has not indicated, however, what it may take to achieve this, reflecting his opposition to the Fed’s sending explicit signals about the path forward for policy.
Many Measures, Mixed Messages
The Fed’s main tool for controlling inflation — raising and lowering short-term interest rates — is a blunt instrument. Interest rates affect the whole economy, not individual sectors, and they don’t have an effect right away.
As a result, central bankers typically try to avoid responding to price changes that they expect to be short-lived. A temporary jump in the price of oil or eggs may be painful for consumers, but there isn’t much policymakers can do about it — and if they try, they may do more harm than good, slowing down the economy in response to a price spike that would have gone away on its own.
“By the time you’ve actually had an effect on inflation, the transitory shock will have passed and you’ll end up tanking the economy for no reason,” said Jonathan Wright, an economist at Johns Hopkins University who used to work at the Fed.
What policymakers care about is the underlying pace of inflation, the rate that prices would rise based on supply and demand in the economy as a whole. But measuring that is tricky — it isn’t always obvious, without the benefit of hindsight, whether an uptick in inflation is a blip or the start of a more troublesome trend.
The best-known method for gauging underlying inflation is also the simplest: Exclude food and energy prices, historically among the most volatile categories. That measure of core inflation gained favor during the 1970s, when repeated oil shocks sent energy prices soaring, and has remained a focus for Fed policymakers.
Still, economists have long recognized that the core measure is imperfect. Food and energy aren’t the only volatile categories — used car prices, for example, soared during the Covid-19 pandemic. And changes in food and energy prices aren’t always temporary. A jump in restaurant prices, for example, may be a result of strong consumer demand — a valuable signal for policymakers.
Economists over the years have developed a variety of more sophisticated methods of measuring underlying inflation. Mr. Warsh highlighted one of them during his Senate confirmation hearing in April: “trimmed mean,” an approach that excludes whichever prices move the most in a given month. As chairman, he has announced a task force to look into how the Fed measures and models inflation.
The most commonly cited version of the trimmed mean measure, published by the Federal Reserve Bank of Dallas, has fallen since the war with Iran began. That could indicate that policymakers don’t need to be as worried about inflation as the standard core metric suggests.
Some academic research has found that the trimmed mean approach does a better job of estimating the underlying trend in inflation than the traditional core measure, at least on average. But its recent record has been less encouraging. It didn’t begin to rise in 2021 until significantly later than other measures, so if the Fed had been focused on the trimmed mean index, it may have been even slower to respond to the highest inflation in four decades.
The problem may lie in the design of the trimmed mean measure, which was based mostly on data from the 1980s through the early 2000s, when inflation was relatively low and prices of some goods were falling outright. That may have left the measure poorly suited to a period of supply chain disruptions, tariffs and other forces that are creating upward price pressures. Researchers at the Dallas Fed highlighted the potential problem in an April blog post.
“The trimmed mean has a blind spot right now, which is that when a bunch of prices jump at once, it discards them,” said Stephen Cecchetti, a Brandeis University economist who helped develop the approach when he worked at the New York Fed in the 1990s.
Researchers at the Cleveland Fed in recent years have developed an alternative measure that tries to correct for the downward bias in the trimmed mean index. That version shows that underlying inflation has picked up in recent months, though not as much as the core measure suggests. Other measures of underlying inflation mostly tell a similar story.
But the proliferation of different inflation measures creates another risk, economists warn: that policymakers, consciously or unconsciously, will focus on whichever measure gives them the answer they prefer.
“You don’t want to give a policymaker, anyone, the chance to choose whichever one of the measures they prefer on a given day,” said Mark Watson, a Princeton economist who has studied the issue.
To Hike or to Hold?
The debate over how to measure underlying inflation isn’t just an academic exercise. It could help determine how the Fed interprets the state of the economy as the shock of oil prices fades.
Officials are split down the middle as to how to respond to the inflation situation in front of them. The projections released this month alongside the Fed’s decision to hold rates steady for a fourth straight meeting showed nine officials bracing for at least one rate increase this year. Eight expected the Fed to stand pat. Only one person penciled in a quarter-point reduction. Mr. Warsh declined to submit his own estimate.
Policymakers face a gamble in either direction. Waiting to act could leave the Fed late and scrambling to contain an overheating economy if, for example, productivity gains take time to accrue or fail to materialize in size. But raising rates unnecessarily could choke off growth that could have helped to keep a lid on prices over time. It would also risk imperiling a labor market that by most accounts is not contributing to inflationary pressures.
Mr. Warsh still appears to be partial to the Fed’s holding its fire, having echoed, at his first news conference as chairman last week, aspects of the productivity case he backed while campaigning for the job.
“If we do our job, we can make strong growth, low prices and strong employment mutually compatible,” he told reporters. He concluded the news conference by saying that “strong productivity-led growth is not something that we fear but something we embrace.”
Those statements were couched in a broader message from Mr. Warsh that the Fed would “unambiguously and unanimously” get inflation back down to its target. In doing so, he carved out a middle path for the Fed that keeps its option open.
“They’re playing for time,” said Jonathan Hill, head of inflation research strategy at Barclays. “Inflation expectations are tame because the market is anticipating the Fed to hike if needed.”
The team at Barclays does not believe the Fed will have to follow through with rate increases and instead forecasts an “indefinite hold.” But other economists do not think officials will get off so easy.
James Egelhof, who worked at the New York Fed and is now chief U.S. economist at BNP Paribas, expects the central bank to unwind a series of cuts it delivered last year and raise rates three times in succession beginning in December. That reflects his view that inflation is “chronically stuck at a moderately elevated level” and that the Fed’s policy settings are no longer restraining the economy.
“We think Warsh is building a case with markets and the public for better-anchored inflation expectations built around his own personal credibility and a renewed institutional credibility for the Federal Reserve,” Mr. Egelhof said. “After over five years of an inflation overshoot, the words will need to be supplemented with action.”
