Kevin Warsh’s preferred inflation measure could come back to bite him

Kevin Warsh, President Donald Trump’s nominee for Federal Reserve chair, told lawmakers that he would like the central bank to change its strategy for measuring inflation.

But Bank of America economist Aditya Bhave warned Wednesday that such a reconfiguration — part of a broader “regime change” that Warsh has promised for the central bank — might not pan out as he hopes.

The Fed has long favored the core price index for personal consumption expenditures, known in short as the core PCE, because it excludes volatile food and energy prices.

But Warsh wants to go a step further, by rooting out extreme price shocks when calculating overall inflation.

“What I’m most interested in is: What’s the underlying inflation rate? Not: What’s the one-time change in prices because of a change in geopolitics or change in beef?” Warsh said at his Senate hearing Tuesday.

“The measures I prefer are looking at things that are called trimmed averages,” Warsh added. “We take out all of the tail-risks, all of the one-off items, and we ask ourselves whether the generalized change in prices is having second-order effects on the economy.”

Under Warsh’s system, Bank of America’s Bhave said, inflation today does look softer. The bank found a 12-month inflation gauge that’s using the trimmed method would have a mean of 2.3% and median of 2.8% as of February. By comparison, core PCE sat at 3%.

Warsh called the current trend in inflation “quite favorable” during Tuesday’s hearing.

But Bhave said that making this switch may mean energy and food — currently excluded — would matter more for Fed policy.

“Even if these shocks get trimmed out, they might still raise the trimmed mean by preventing other shocks from getting trimmed,” Bhave said. “This is ironic because Warsh also argued yesterday for looking through one-off, supply-driven price increases.”

In other words, by trimming only the most extreme readings, some more minor spikes in inflation — perhaps caused by food and energy prices jumping — could creep into the inflation reading under Warsh’s method and cause it to be higher than the Fed’s current preferred view.

And Bank of America’s data showed that’s occurred in the past.

A trimmed-median inflation gauge tracked by Bank of America was higher than the core PCE in 2019 and 2020. In those years, using a trimmed basket would have encouraged a hawkish stance from the Fed.

If trimmed inflation outpaced the core PCE in the future, Bhave said, Warsh would likely have to stand by his view, tying his hands.

“To preserve Fed credibility and avoid optics of cherry picking, Warsh will need to stick with his preferred metrics even when they are outpacing the core,” Bhave said.

Critics of Warsh said they expect him to sway the Fed in a direction that appeases Trump rather than by what’s best for the economy.

During Tuesday’s hearing, Warsh pushed back on the idea that he would lower interest rates solely at the request of Trump. But the former Fed governor faced tough lines of questioning over his wealth and ability to break with Trump.