Fed Chairman George Warsh faces inflation credibility test: analysis

For Kevin Warsh, trust is everything. Congressional hearings this week showed how difficult it will be for the new Federal Reserve chairman to maintain policy.

In back-to-back testimony in the House and Senate on Tuesday and Wednesday, Mr. Warsh made few, if any, major gaffes amid intense questioning from Democrats and supportive comments from Republicans. But there is complete agreement on both sides that prices are still rising too fast, and the Fed chair needs to quickly follow through on his promise to maintain price stability. Otherwise, he risks losing support both within the Fed and within the chairman’s traditional power base on Capitol Hill.

Part of Mr. Warsh’s challenge is that he wants to rethink how the Fed measures inflation itself. Two important price indicators, the Consumer Price Index and the Producer Price Index, showed unexpected declines this week. In June, the CPI fell by 0.4% and the PPI fell by 0.3%.

“I think any central bank would be happy to see the data moving in the right direction,” Warsh said on Wednesday. “In my view, these are all imperfect measures of the underlying state of inflation,” he said.

Although the Iran war has increased U.S. gas prices, Warsh said it’s not necessarily inflation, at least not the kind of inflation the Fed can handle.

“Certain price shocks happen to certain prices that we have no control over, but we don’t want to say that we can’t control inflation over the medium term. That’s our job,” Warsh said.

Warsh has appointed a special committee to answer his questions about the nature of inflation, but it is expected to take several months to produce results. The Federal Reserve is scheduled to meet in two weeks to decide on the direction of interest rates, but voters appear divided over whether factors such as a boom in data center construction to support the growing artificial intelligence industry are starting to lead to higher prices across the board.

Federal Reserve President Lisa Cook said in a speech Wednesday that AI spending could fuel inflation. He warned of “significant price increases for chips, other high-tech equipment, software and utilities.” This is changing the overall view of inflation, he said, adding that “inflation risks outweigh employment risks.”

Warsh said the debate over AI spending is “one of the good family battles” at the Fed. He said supply is likely to increase to keep up with demand. “I don’t think that changes in prices are necessarily inflationary because I think there is a supply response. In that sense, this is different from foreign conflicts and the possibilities that they cause, which tend to reduce the supply side of the economy.”

It remains to be seen whether a separate task force on AI will help resolve this debate. Some Republican senators praised the intellectual diversity of the members of Mr. Warsh’s task force, which the chairman said included a “team of rivals.”

However, it is not a given that the Select Committee would disagree with Warsh’s views. All members of Warsh’s AI Task Force are extremely bullish on AI. As Democratic senators pointed out Wednesday, there is no one in the group who clearly speaks for workers.

Mr. Warsh brings a conservative economic tradition to the Fed. His monetary policy report to Congress reinstated the practice of reporting the size of the money supply. Mr. Warsh disagrees with the Federal Reserve under former Chairman Jerome Powell, who believed that information about the money supply was essentially unrelated to inflation. Although he doesn’t want to return to the days when the Fed targeted the size of the money supply when making policy decisions, he believes certain monetary measures can provide useful information about inflation.

“We have this outdated idea that monetary policy has to do with money,” Warsh said.

The risk for Mr. Warsh is that unless inflation starts to fall in real terms soon, all these decisions will be scrutinized for signs that ideology has overtaken dispassionate analysis. Although Warsh has declined to say how he will decide interest rates, the market now overwhelmingly expects the Fed to raise rates by the end of the year. Warsh needs to be on the right side of that decision.

If Mr. Warsh loses out to other committee members in the debate over AI spending and rates rise, the chairman’s credibility will be undermined. An even worse outcome would be for Mr. Warsh to win the argument and keep interest rates flat or low, but inflation would accelerate again.

This kind of loss of trust is a problem that even the best response team cannot solve.