Viewpoints

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.

Korean equities, alongside Japan, Taiwan and US technology stocks, were identified at the outset of the Iran conflict as some of the most compelling investment opportunities. All have outperformed the MSCI World Index, but Korea has emerged as the clear standout.

The story extends beyond the stock market. The economy has strengthened markedly, supported by both domestic and external demand. GDP growth accelerated from 1.6% year-on-year in 4Q25 to 3.4% in the first quarter of 2026, driven by robust consumption and non-residential investment spending. Exports have also rebounded strongly, leaving Korea firing on all cylinders (Figure 1).

With food and energy prices surging in recent months, you might think that households would be cutting back on their real spending on “discretionary” goods and services, i.e., total goods and services excluding purchases of food, energy, clothing, housing and healthcare. After all, households would have to use more of their income to purchase higher-priced food and energy goods and services, leaving less income for the purchases of more discretionary goods and services. However, real discretionary (as I have defined it) household spending in April 2026 was 53.9% of total real spending, the highest percentage registered since the data started being reported, January 1959.

Plotted in Chart 1 are the monthly observations of discretionary real personal consumption expenditures as a percent of total expenditures (the blue bars) along with monthly observations of the personal consumption chain price index for food and energy goods and services (the red line). Notice that in the last three months starting in February 2026, the food-energy price index started rising, as did relative real consumer spending on discretionary goods and services. Similarly, back in 2022, food and energy prices were rising after Russia’s unprovoked invasion of Ukraine and relative real consumer discretionary spending also rose for several months. What might explain this counterintuitive phenomenon?

Movements in the Federal Reserve Bank of Philadelphia’s state coincident indexes in April were again muted. In the one-month changes, none had increases as high as 1 percent, and only three (West Virginia, Rhode Island, and South Dakota) had gains above .5 percent. On the other side, only four states had declines, all being very modest (Connecticut’s -.16 percent was the largest). Over the three months since January, five states—West Virginia, North Dakota, Idaho, New Hampshire, and Ohio—had increases of 1 percent or higher, with West Virginia’s 1.28 percent on top. Hawaii and Connecticut were the only state with declines; Connecticut’s -.33 percent being the largest. Over the last twelve months, Nevada, Ohio, Idaho, and California clocked increases above 3 percent, with Nevada’s 3.57 percent the highest. Four states were down, with West Virginia’s 2.88 percent loss (obviously conditions there have been turbulent, with steady losses over the year ending in February followed by gains the last two months) being almost three times the size of any other.

The independently estimated national estimates of growth over the last three and twelve months were, respectively, .53 and 1.79 percent. These may be a touch softer than the state figures would suggest.

State labor markets were a bit firmer in April than in prior months, but insufficient to reverse a long lethargic spell. Six states saw statistically significant increases in payroll from March, though none was especially large (Florida had a 40,500 gain, or .4%, while New Mexico was up .6%, or 5,700). Over the last 12 months, the only ones to see statistically significant changes were DC (down 39,100, or a whopping 5.1%, reflecting the slashing of federal jobs), Oregon, down 1.2%, and Nevada, up 1.9%.

Three states reported statistically significant drops in their unemployment rates in April, while two reported declines. None was larger than .2 percentage point (Connecticut’ was up that amount while Ohio’s fell than much). Once again, about half of the states had rates statistically different than the nation’s 4.3%, but once more California was the only one of the very largest states to do so. Rates at or above 5.0% were in DC, Delaware, Nevada, California, Washington, and Illinois, with DC’s again 6.3% the highest. Alabama, Hawaii, North Dakota, South Dakota, and Vermont had unemployment rates under 3.0%, while South Dakota’s 2.4% was the lowest in the nation.

Puerto Rico’s unemployment rate was unchanged at 5.6% and the island’s job count rose 3,600.

Warsh and the bond market vigilantes

The recent bond market sell off is a reminder of the many risks to the market, including Warsh’s appointment as Fed chair. The market is justifiably worried about three of Warsh’s main policy views: (1) productivity growth will solve the inflation problem without help from the Fed, (2) the Fed should be selling off most of its bond holdings and (3) the Fed should be focused on the weakest of the core inflation metrics—the “trimmed mean” PCE deflator.

Independent, but in agreement

President Trump has made it abundantly clear that he wants lower interest rates. Indeed, he has said he will not appoint a Fed chair who does not believe major cuts in the funds rate are warranted and he expects the Fed to cut under Chair Warsh.

Last month, Bessent offered a more flexible message to the Fed. He noted the uncertainty around the Iran war, saying “if they [the Fed] want to wait for some clarity, I understand that.” Indeed, “we should wait for the new chairman, Warsh, and let him lead the next cycle.” Looking ahead, he said, “the conflict will end, prices will come down, and then headline inflation will come down.” This suggests a short honeymoon period for Warsh, followed by a string of rate cuts.

In his campaign for the Fed chair, Warsh has been adamant that he has independently arrived at a similar conclusion. He does not want to lower rates because the President wants it, but because economic fundamentals warrant lower rates. Specifically, he strongly supports two arguments. First, the Fed does not need to hike rates to bring inflation down. Quite the opposite, surging productivity will not only solve the inflation problem, but demands that the Fed cut rates to accommodate .

Second, he argues that any upward pressure on inflation is transitory. Indeed, in his testimony, he argued that the Fed should shift to the “trimmed mean” PCE as its preferred measure of core inflation. This metric strips out the components with both the highest and the lowest inflation. In March, the year-over year increase was just 2.4%, and much lower than other metrics (chart).