Viewpoints

*The dramatic spike in oil prices generated 3 months of outsized increases in CPI and PCE inflation that pushed up their yr/yr measures.

*The Fed has kept rates on hold and did not accommodate the negative supply shock, core inflation measures have not increased much, and inflationary expectations have remained anchored.

*Oil prices have fallen sharply, and if current prices stick close to current levels (around or below $75/barrel)—which is uncertain as inventories need rebuilding--continued rapid price declines in gasoline and other energy may result in several months of declines in the CPI and PCE Price Index.

*This would ease some price pressures on consumers and let the Fed breath more easily.

In a note in mid-April, I described how the spike in oil prices from $65/barrel to $95/bbl would temporarily boost the monthly inflation data for about three months as retail prices adjusted to the higher oil prices. I emphasized the importance of the Fed not accommodating the negative supply shock, which would keep its impacts temporary, limit the pass through of the higher oil prices to the prices of nonenergy goods and services, and constrain inflationary expectations. I noted that if oil prices remained around $95/bbl, after several months of outsized increases, the monthly inflation data would revert to their prior increases, while their yr/yr measures would rise to absorb the temporary monthly spikes.

I continued: “However, if oil prices fall, subsequent months' CPI and PCE Price Index data would possibly decline, and the temporary months of deflation would reduce the general price level from its oil price-driven peak.” That process is now beginning to unfold. Yippee: a positive supply shock that involves a partial reversal of the negative supply shock imposed by the conflict in the Middle East and relief to consumers and businesses.

Here’s the situation: in the prior 12 months through February 2026, CPI inflation was 2.4%, averaging a 0.2% increase per month, while PCE inflation was 2.9%, averaging a 0.3% rise per month. The oil price spike pushed up CPI inflation 0.9%, 0.6% and 0.5% in March, April and May, lifting its yr/yr inflation to 4.2% in May, while PCE inflation rose 0.7% and 0.4% in March and April, lifting its inflation to 3.8% in April (PCE inflation for May will be reported tomorrow). See Chart 1. During these months, both core CPI inflation and PCE inflation rose a bit (CPI: 0.2%, 0.4% and 0.2%; PCE: 0.3% and 0.2%), but the details of the CPI indicate that the pass through of the oil price spike was fairly limited to specific categories, including energy services (electricity and utilities) and airline fares. Most categories in the CPI showed little effect of the higher oil prices.

During the June 17 press conference after the FOMC meeting, the new Fed Chairman, Warsh, announced the establishment of five task groups. These groups will address various topics, such as Fed communications, balance sheet policy, inflation framework, employment and productivity, and data sources that assist policymakers. The proposed changes to policymakers' practices could significantly affect how the Fed plans to achieve its objectives, compelling Wall Street to adapt to a new approach.

Fed Communication: Policymakers usually prioritize items based on their significance, which is why Fed Warsh considers Fed communication as the foremost concern. Fed Warsh has publicly stated that the "Fed" communicates excessively and too frequently. A notable shift in Fed communication was evident during his initial FOMC meeting. The press release was short, with no forward guidance, and Fed Warsh did not engage in offering forecasts for growth, unemployment, inflation, and policy rates. It wouldn't be surprising if the Fed decides to drop the "dot plot" and "forward guidance" in upcoming meetings. Wall Street might protest, but how many companies receive a "roadmap" every six weeks? Reducing risk and speculation in the financial markets is a good thing.

Fed's Balance Sheet Policy: Fed Warsh has long argued that the Fed's balance sheet is too big. It is unclear if Mr. Warsh would change the size, composition, or both, but he wants to reduce the Fed's footprint. At the June press conference, when asked if he thought Fed policy was restrictive, he argued if you look at what is happening in the financial markets, it is hard to say policy is restrictive. Financial markets run on liquidity, and Fed Warsh thinks the Fed balance sheet is providing too much liquidity.

Existing Data Sources: Fed Warsh attempts to imitate former Fed Chairman Greenspan in various aspects, yet unlike Greenspan, who was a "data junkie," Warsh does not share this trait, particularly regarding economic data. Fed Greenspan spent a lifetime studying microeconomic data and was a big fan of survey data from the purchasing managers and others. However, the most reliable and hardest data originates from government statistical agencies, including the Census Bureau, Bureau of Labor Statistics, and Bureau of Economic Analysis. If Mr. Warsh wants to get a more accurate account of the economy, he would be wise to ask Congress to increase funding for the statistical agencies.

Productivity and Jobs: Mr. Warsh is of the opinion that "AI" will have a positive impact on output, employment, and productivity, although the extent and timing of these benefits are unpredictable. If Fed Warsh takes a similar approach to Mr. Greenspan, he will allow the economy and financial markets to guide him.

Inflation Frameworks: Mr. Warsh has argued that "trimmed inflation" measures offer a better guide of underlying inflation versus widely used "core measures". Yet, if Mr.Warsh is serious about revisiting inflation frameworks, then there should be a serious discussion about inflation measurement. The Fed's price target, the PCE deflator, is not a direct measure of inflation, as nearly a third of it comes from non-consumer, non-market prices. The CPI has its flaws, and both measures include an implied rent series for homeowners. Price statistics need to be relevant, objective, and reflective of people's actual experiences. Currently, price measures do not meet these standards.

As Mr. Warsh stated, a change in leadership is a "timely opportunity to review current practices" and review what still works and what should be changed. Wall Street must adapt as the operation of monetary policy could change significantly under Fed Warsh's leadership.

State labor markets in May were again somewhat firmer. Two states saw statistically significant increases in payrolls from April: North Carolina reports a 17,400 increase (.3 percent), and West Virginia’s 9,700 increase was a whopping 1.4 percent. No state had a statistically significant decline, and only a few reported insignificant drops.

Seven states reported statistically significant drops in their unemployment rates in April, though none was larger than .2 percentage point. Alabama reported a .2 percentage point increase. Rates at or above 5.0 percent were in DC, California, Nevada, Washington, Delaware, and Illinois, with DC’s 6.1 percent the highest. Hawaii, North Dakota, South Dakota, and Vermont had unemployment rates under 3.0 percent, while South Dakota’s 2.1 percent was the lowest in the nation.

Puerto Rico's unemployment rate was unchanged at 5.6 percent and the island’s job count rose 1,500.

The comparisons are hard to avoid. Soaring valuations, massive capital expenditure on data centres and AI infrastructure, and near-universal conviction that a transformative technology is about to reshape the economy. To many observers, today looks uncomfortably like the late 1990s.

The parallel is understandable. It is also, on the most important dimension, wrong — and Haver data help explain why.

The critical variable: who holds the debt

Investment booms become dangerous when they are financed by leverage. The late 1990s are a textbook case. As internet enthusiasm intensified, US corporations borrowed heavily to fund infrastructure buildout. By 2000, the non-financial corporate sector was running a financial deficit approaching 4% of GDP — spending substantially more than it earned. When expectations proved too optimistic, investment collapsed, and corporate deleveraging deepened the downturn.

The Bureau of Labor Statistics was unable to sample prices during the government shutdown last October. Consequently, it assumed no change in shelter costs for that month. Given the particulars of how the BLS measures rents, the resulting understatement of the level of shelter costs was not corrected until April, when shelter costs jumped 0.6%, roughly double the true monthly increase.

As we approach the next report on consumer prices, bear this in mind. Going forward, monthly changes in shelter costs will be correct. However, because we often examine inflation over longer intervals, the legacy effect of the government shutdown on shelter costs is not yet fully in the rearview mirror. From October through March the level of shelter costs was low by one month’s increase. Therefore, after March, any change in shelter costs calculated over an interval starting from the months of October through March will overstate the increase over that interval by one month’s increase in rents. The overstatement is magnified if the change is expressed at an annual rate.

Kevin Warsh returns to the Federal Reserve as the new Fed Chair. His return occurs at a crucial time for the Federal Reserve, as its independence has been threatened multiple times over the past year. However, Mr. Warsh's greatest challenge may be preserving the Fed's credibility.

Mr. Warsh joins the Fed with controversial views on inflation measurement. Mr. Warsh advocates that policymakers move away from conventional inflation metrics and instead focus on "trimmed averages." This approach excludes the "tails," or the items with the highest and lowest price changes in a given month.

"Trimmed" inflation-like core measures are attempts to remove price outliers from the rest. However, inflation cycles are not linear; they include outliers and the composition changes over time.

But any effort by the Fed to alter the targeted measure would damage its credibility, as investors and analysts recall the Fed's actions in 2020.

In 2020, in response to criticism for consistently falling short of its 2% inflation target, the Fed introduced an "inflation-averaging targeting" framework. This approach would allow inflation to surpass the 2% mark to compensate for times when it was below target.

During the five years before inflation-averaging was implemented, the personal consumption core deflator was below target in four of five years, averaging 40% below target. Meanwhile, the consumer price index exceeded the target in three out of those five years, averaging just under 2%.

However, over the past five years, inflation trends have notably reversed, with both the personal consumption deflator and the consumer price index averaging several hundred basis points above the 2% target. This trend persists in 2026.

If the Fed opts to alter its inflation target while inflation is significantly above the target, especially after modifying the framework to promote more inflation and persistently low official interest rates when inflation was below target, it would set a bad precedent. Critics would argue that the new Fed Chair is adjusting the inflation target to squash calls for a rate hike, while opening up the possibility of an official rate cut later, which is what President Trump is seeking from his nominee.

Credibility is built by consistently following its mandate without retreating or changing targets, which can falsely suggest that you are taking the necessary actions to control inflation.

If Fed Warsh urged the FOMC to implement a new inflation target, he would risk significantly damaging both his and the Fed's credibility. Additionally, the bond market would strongly express its disapproval by substantially increasing long-term interest rates. What choice will Fed Warsh make: satisfy the individual who nominated him or prioritize the most important people, the investors?

Iran’s closure of the Straits of Hormuz on March 2 has sent fuel costs spiraling upwards. The Fed’s preferred measure of inflation is of the price index for core personal consumption expenditures (PCE). These exclude consumers’ direct (or “final”) purchases of gasoline & other motor fuel. However, increases in the cost of fuel used to produce and transport core consumer goods & services may pass through to core prices. In a recent paper I present compelling empirical evidence that the pass-through of intermediate fuel costs to final core consumer prices is highly significant and could contribute as much as 0.8 extra percentage points to second-quarter annualized core inflation.

I began by constructing a price index for the intermediate consumption of the three major fuels: diesel fuel, gasoline, and jet fuel. In doing so I assumed the domestic consumption of diesel fuel and jet fuel is all intermediate while treating as intermediate the domestic consumption of gasoline not included in PCE. The average (since 1979) shares of the three fuels in intermediate use are: diesel fuel (62%), gasoline (25%), and jet fuel (14%), but recently those shares are 66%, 13% and 21%, respectively.

The U.S. financial headlines focus on high stock market valuations, questioning them as too high, the concentrations of capitalizations, questioning them as excessive, and big cap AI companies that are getting bigger and going public at higher capitalizations. Here’s a few economic observations on these trends and an international comparison.

The economy. The U.S. economy has been quite resilient to recent shocks—erratic tariffs policies and the surge in oil prices--and continues to expand. Economic growth has been driven by consumer spending and solid gains in business investment while residential investment has weakened and subtracted from growth. Currently, while the ongoing Middle East conflict and high oil prices and tariffs are weighing on consumer pocketbooks, and real disposable income has fallen in each of the last three months ((Feb-Mar-April), households have reduced their rates of personal saving to smooth real consumption. Nominal GDP, the broadest measure of current dollar spending and aggregate demand, has risen 6% in the last year and at a 5% annualized pace in the last two quarters. Sustained high energy prices are likely to adversely impact real consumption.

Real interest rates remain moderate, the economy and the probability of recession is low. Of note, history, at least going back to the 1950s, shows that the S&P500 continues to rise and does not peak until just before recession.

Profits. Corporate profits are rising briskly, much faster than GDP (Chart 1). That’s also typical during economic expansions. Operating profits have risen 18.7% in the last two years and are up 63.3% since 2019, just before Covid. During those same two periods, nominal GDP rose 10.8% and 47.7%, respectively.