Kevin Warsh's Preferred Inflation Measure: A Potential Double-Edged Sword

Background

Kevin Warsh, a former Federal Reserve governor and one-time nominee for Federal Reserve chair, advocated for a change in how the central bank measures inflation. Warsh believes the Fed should focus on the "underlying inflation rate" by using trimmed averages, which exclude one-off items and tail risks.

The Trimmed Average Approach

Warsh's preferred method involves removing extreme price shocks from inflation calculations. Currently, the Fed favors the core price index for personal consumption expenditures (core PCE), which excludes volatile food and energy prices. The trimmed average goes further by eliminating the most extreme price movements.

Potential Implications

Bank of America economist Aditya Bhave suggests that while this approach might show softer inflation today, it could lead to unintended consequences. By trimming only the most extreme readings, smaller spikes in food and energy prices could creep into the inflation reading, potentially causing it to be higher than the Fed's current preferred view.

Historical Context

Bank of America's data indicates that a trimmed-median inflation gauge was higher than the core PCE in 2019 and 2020. Had the Fed used this measure, it might have adopted a more hawkish stance.

Concerns and Criticisms

Critics worry that Warsh's proposed changes could be influenced by political considerations. They fear he might prioritize appeasing political figures over making decisions based on sound economic principles.

Actionable Takeaways

Understanding the nuances of inflation measurement is crucial for investors and policymakers. The potential shift towards a trimmed average approach could impact investment strategies and monetary policy decisions.

The core price index for personal consumption expenditures, which excludes volatile food and energy prices.

A method of measuring inflation that excludes extreme price shocks to focus on the underlying inflation rate.

He believes it provides a more accurate view of the underlying inflation rate by removing one-off items and tail risks.

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