Inflation remains persistent and stubborn. The reason is a little more complex than trade disputes or the bombing in Iran. Inflation is sticky because services inflation is running well above 3%, and the U.S. is a majority-services economy. Here is the underlying data – FRED IA001260M.
Inflation was exceptionally low between 2010 and 2020 because Baby Boomers were consuming fewer goods, and we were importing goods deflation from China (we bought lower cost goods from them since their costs to produce were cheaper).
So, if services inflation is relatively static around 3% and we no longer have goods deflation coming from China, then baseline inflation is mathematically likely to be higher. As such, the Fed’s 2% inflation target remains elusive.
Interest rates are currently closer to normal than not. For example, the 30-year average for a 30-year fixed-rate mortgage is 5.65%; this is not far off the current quote of 6.43%. Some in the political sphere are calling for lower interest rates because of AI productivity, an alternative measure of inflation, or some other reason. By one of our measures, the Fed funds rate is a touch loose at present, not too tight.
I recently heard a very interesting interview with Dr. Alan Greenspan, the former Fed Chair, who died recently at 100. On Fed independence, he said that all manner of politicians asked him to lower rates for all manner of reasons. None of them, he said, not one, ever asked him to raise rates.
Return to the past: new Fed Chair Warsh. Much of the present-day Fed’s persona comes from the tempo, interventions, and communications used to address the financial crisis. Do we really need that? Warsh thinks not, and we tend to agree.
Warsh was a member of the FOMC from 2006 to 2011, but the key thing to know about Warsh is that he was essentially Fed Chair Bernanke’s lawyer during the financial crisis. They worked side by side, day by day, during that period. Warsh is certain to have seen firsthand some of the heroic interventions used, some of which may have been within the gray area of the law.
He wants to return to less forward guidance, with markets discounting the direction of rates rather than being told. Further, Warsh believes the Fed’s balance sheet should shrink and that the Fed should not be as involved in the day-to-day workings of the markets.
That sounds great, but it may be naive. Why?
First, due to three rounds of so-called QE, the Fed is part of the baseline plumbing of the financial system. The system is used to, and relies on, some of the basic mechanisms the Fed uses on a daily basis to support liquidity. Also, before the Fed’s balance sheet ballooned, U.S. Treasury debt was only $9 trillion; today, that figure is $39 trillion. It takes both the Fed and Treasury to manage that.
Warsh will likely stir things up and change some things badly needed, but in total, he will probably try to hit it straight down the middle.