Kevin Warsh’s complicated inheritance

Kevin Warsh’s swearing-in ceremony at the White House on Friday was a jolly affair. The new US Federal Reserve chair took the oath of office in front of no fewer than 16 giant star-spangled banners. A band played. But most important of all, President Donald Trump behaved well. He praised Warsh’s record, spoke glowingly about how much the new Fed chair “has the deepest respect and reverence for the institution he will lead” and urged Warsh to be independent.

“Honestly, I really mean this. This is not said in any other way. I want Kevin to be totally independent. I want him to be independent and just do a great job. Don’t look at me. Don’t look at anybody. Just do your own thing and do a great job. OK?”

While Trump stressed that the Fed should not thwart a boom, the level of indirect bullying was minimal. This was nothing like the 1970 speech by Richard Nixon at the swearing-in of Arthur Burns, when the former US president said he respected the Fed’s independence then in the next sentence added: “I hope that independently [Burns] will conclude that my views are the ones that should be followed.”

Warsh, for his part, spoke of his honour in becoming the 17th Fed chair, the importance of the mandate to pursue price stability and maximum employment, and the need to learn from the central bank’s successes and failures. He was more gracious to the institution than he had been in his confirmation hearing in front of the US Senate banking committee.

The softening of Warsh’s criticisms of the Fed and Trump’s praise of independence will help bolster the necessary belief in financial markets that the central bank will operate with independence.

A bigger gift to Warsh from the president might be an imminent extended ceasefire agreement with Iran, pending the reopening of the Strait of Hormuz and a peace deal. Without one, the main job of the Fed this year will be containing yet another inflationary episode caused by Trump himself.

The US inflation challenge

The Fed has not achieved its price stability mandate for the past five years and US inflation is currently moving away from target. As the chart below shows, the inflation figures are concerning despite what measure you use.

Clearly, in the middle of an energy shock, headline consumer price and producer price inflation will rise quickly. April annual CPI inflation rose to 3.8 per cent, with producer prices 6 per cent higher than a year earlier. US consumer prices are also increasing faster than in other G7 countries because the country’s low road fuel taxes ensure that the wholesale price of gasoline is a larger proportion of the final cost.

But direct energy prices are not the only worrying thing. Core measures of inflation are moving away from target, as is clear from our own measure “FT core”. FT core combines a suite of underlying inflation signals and weights them by their predictive power to explain long-term inflation trends. As the chart below shows, none of the four most heavily weighted components of FT core inflation is telling a comforting story.

The weighted median of prices is relatively stable, but at an inflation rate of 3 per cent, not the target 2 per cent level. Other measures of underlying price pressures are both above their average levels and rising.

These measures show that not only are average prices rising faster than desired, nearly all goods and services are increasing in price. When retailers are all looking to raise prices and succeeding in doing so, the danger of inflation becoming a self-reinforcing cycle increases greatly.

The supply-demand balance

The Fed should not just look at trends in inflation. It must also consider the underlying causes of price movements and how they will affect costs over the years ahead. Here, Trump was urging Warsh not to seek to quell a boom if it is caused by an improvement in supply, such as with AI, which might significantly enhance productivity.

But it is not that simple. AI might bring a positive supply shock. But expectations of a brighter future brought about by the technology could easily unleash an inflationary consumer boom now. After all, if you know you are going to become much richer, why wait?

The truth is these considerations are premature. At the moment, there is a big energy supply shock, which is negative for consumers. This is the immediate supply-demand balance the Fed needs to consider. And, at present, the inflationary impacts are the main concern.

Some worrying inflation expectations

Central banks at the moment must ensure the energy price rises, which they can do nothing about, do not morph into embedded inflation, where companies raise prices because they expect everyone else to do so.

There is no sign of long-term US inflation expectations losing the anchor with the 2 per cent target. But, as the chart below shows, two-year market break-even inflation expectations between 2028 and 2030 have moved higher this year. This is something the Fed needs to keep an eye on.

The good news is that household expectations (apart from some volatile figures from the University of Michigan survey of consumers) have been under control so far.

A wary Federal Reserve

Having faced constant criticism from Trump and Warsh, it is natural for Fed officials to be wary. But there has been something of a revolt on the Federal Open Market Committee in recent weeks against the idea that the US central bank is just waiting for the right time to ease policy.

Three FOMC members voted against the easing bias in the Fed’s statement following last month’s meeting. The minutes showed their views were much more widely shared than the vote suggested.

And just before Warsh was sworn in on Friday, Fed governor and Trump-appointee Christopher Waller gave a speech where he said inflation risks had risen sharply and that it was now appropriate to remove the guidance that the next move in rates would probably be down. “I do not expect to support a change to the policy rate in the near term. The next move, whether it is a hike or cut, will depend on the data,” he added.

All of this suggests the Fed is in wait-and-see mode as Warsh takes the reins. Financial markets have probably jumped the gun in pricing in a rate rise. But the best hope for easing borrowing costs soon would be a rapid peace agreement in the Gulf and the steady reopening of the Strait of Hormuz.

What I’ve been reading and watching

One last chart

A nice article on the BoE’s Bank Underground blog shows that UK financial markets have been much more responsive to surprises in inflation data since 2023. If inflation is above expectations, their interest rate expectations rise by multiples of the amount they would before 2022.

It is, of course, moot whether a central bank should want market expectations to be this data-dependent. But it certainly shows that financial markets now watch UK inflation data hawkishly and think the Monetary Policy Committee will act on it.

Central Banks is edited by Harvey Nriapia