MNI POLICY: Warsh Faces Resistance On Inflation, Productivity

Incoming Federal Reserve Chair Kevin Warsh will need to do some heavy lifting to convince FOMC colleagues of two key pillars of the views he has expressed over the past year – that policymakers can look through supply shocks and that productivity gains will bolster the central bank’s ability to lower rates. 

Current policymakers are increasingly worried that the energy shock is one straw too many after five years of above-target inflation, which is threatening the credibility of the Fed's 2% target. 

Tariff-driven inflation effects look largely played through, but the Dallas Fed’s energy experts say it will take at least six months after shipments through the Strait of Hormuz resume before supply chains and oil production fully recover.

Worse, the April CPI report is seen as a harbinger of more persistent price pressures similar to those experienced in the aftermath of Covid. In particular, services inflation was robust, with both owners' equivalent rent and the supercore measure rising 0.5% on the month, indicating that price pressures are spreading well beyond the goods sector. 

With labor market data showing stabilization, that means the balance of risks is now skewed toward higher inflation. 

Indeed, officials are now debating whether to shift the language of their policy statement to reflect the possibility that the next move in rates might not necessarily be a cut. 

All of this makes officials skeptical of their ability to look past the energy price shock, especially given that they were burned by the initial perception that the post-Covid inflation would be “transitory.” They prefer to now stay on hold until there is more clarity on the persistence of the inflation resurgence. (See MNI INTERVIEW: Warsh Fed Won’t Manage To Ease Soon-Hubbard)

“More than five years of above-target inflation has reduced my patience for 'looking through' another supply shock,” Boston Fed President Susan Collins said this week.  

PRODUCTIVITY STORY

In the run-up to his nomination, Warsh argued that AI is a transformative technology with productivity benefits that will allow the Fed to run the economy hotter without generating as much inflation. 

Fed officials including outgoing Chair Powell, who has decided to stay on as governor due to ongoing legal action against the central bank, have embraced the idea that a recent bump up in productivity growth could be accelerated by AI. 

Still, there is very little appetite among policymakers to take pre-emptive action in the form of rate cuts by simply relying on the future promise of AI – they would like to see hard, consistent data beforehand. (See MNI POLICY: AI Boom Complicates Fed's Path To Lower Rates)

Officials also point to three counterweights to the positive productivity boom story. First, higher productivity will over time raise the neutral rate of interest. Second, hopes for future income growth because of expectations of a future expansion in productive capacity could lead to a wealth effect that is inflationary as consumers and businesses pull forward spending. The capex boom spurred by investment in AI data centers could also be inflationary in the short run.

BALANCE SHEET 

Warsh’s desire to significantly reduce the balance sheet will be another uphill battle, because most Fed officials are comfortable with the current ample reserves regime. 

Moreover, they worry that any effort to take quick action on the Fed’s asset holdings could lead to instability in the Treasury market. 

Instead, Warsh might need to undertake the kind of regulatory reforms that will gradually reduce banks’ needs for reserves, eventually allowing for a smaller Fed footprint in financial markets. (See MNI INTERVIEW: Warsh Signals Caution On Balance Sheet Plans)