Kevin Warsh can’t reopen the Strait of Hormuz
Federal Reserve Chairman Kevin Warsh looks on during his first news conference since taking the helm at the central bank
New York (CNN) — The public is fed up with the high cost of living, and the Federal Reserve is once again under pressure to act.
Kevin Warsh, the new Fed chairman, has vowed to get inflation back to 2%. Some investors suspect the Warsh-led Fed will show it’s serious about that pledge by raising rates as soon as Wednesday.
And yet: As powerful as the Fed is, its inflation-fighting tools are limited when it comes to combating the supply-driven inflation America is facing now.
The Fed can’t conjure a durable ceasefire in the war with Iran, reopen the Strait of Hormuz, nor disappear President Donald Trump’s high and volatile tariffs.
“Rate hikes won’t keep the bombs from dropping,” said Benson Durham, a former Fed official and founder of DASM LLC, an independent research firm.
Supply trouble causing inflation
The Fed mostly put out the post-Covid inflation fire by spiking interest rates starting in 2022. Those rate hikes were aimed at cooling overheated demand, giving supply a chance to catch up.
But today’s inflation is different.
First, it’s not as severe. Inflation is hovering at about 3.5%, above the 2% target but a far cry from the 9.1% inflation of mid-2022.
Second, today’s economy is not overheating with gangbusters demand. Hiring is weak. Wage growth has cooled, barely keeping up with prices.
Instead of red-hot demand, inflation is mostly being driven by supply problems that are making so many things more expensive: The war with Iran has derailed the flow of energy from the Middle East, lifting prices on diesel, gasoline and jet fuel. High tariffs have also driven up the cost of some goods, though not by as much as many feared.
“Monetary policy 101 says when there is a supply shock, don’t respond. Follow the script. It’s worked pretty well,” Mark Zandi, chief economist at Moody’s Analytics, told CNN in a phone interview. “Bottom line: I don’t think they should raise rates.”
‘Dangerous game to play’
Zandi warned that raising rates to cool demand could tip over the stock market, which could take down the shaky job market.
“That’s a dangerous game to play. The labor market is weak and it wouldn’t take a lot to push us into a recession,” Zandi said.
Former Fed Chair Janet Yellen argued last month that the “default strategy” for the Fed should be “looking through supply shocks,” instead of being tempted into rate hikes.
“Monetary policy cannot tame supply-driven inflation without exacting unacceptable unemployment costs,” Yellen said at a Brookings event.
The exception, according to Yellen, would be if inflation expectations skyrocket. That matters because if the public and investors start to doubt inflation will get back to normal, workers would likely demand major wage hikes and companies would preemptively raise prices. It can become a self-fulfilling prophecy.
But economists say inflation expectations, especially market-based measures, are not near the danger zone.
Moody’s estimates that about 0.66 percentage points of forecasted inflation at the end of this year will be due to the Iran war. Another 0.17 percentage points comes from tariffs and trade restrictions, and a smaller amount from restrictive immigration policy.
“None of those things will be solved by higher rates,” said Stephanie Roth, chief economist at Wolfe Research.
Goldman Sachs economists concluded in a recent report that there is “little reason to think” limited rate hikes would “provide much help in bringing inflation down.”
AI is lifting prices, too
However, demand is playing a role when it comes to the artificial intelligence boom, which has driven up prices for memory and other components. Moody’s estimates AI will boost inflation by about a quarter of a percentage point, in no small part thanks to the massive amount of resources being poured into the infrastructure it needs.
Apple recently sharply lifted prices on the MacBook, iPad and other products, blaming “an extraordinary surge in demand for memory and storage” linked to the data center buildout as companies rush into the AI market.
Given the gobs of money pouring into AI, Zandi doubts Warsh & Co. can dramatically impact that trend by simply raising rates a few times.
“That train has left the station and is barreling down the tracks. It won’t be stopped by a rate hike or two,” Zandi said.
Warsh keeps Wall Street guessing
Even though the Fed decision is just a day away, there is an unusual amount of drama over what officials will do with rates.
Normally, Fed officials drop enough hints during speeches and interviews that Wall Street has a pretty good sense for what will happen. But today there is a real debate, with the market pricing in a 38% chance of a hike and a 62% chance of no change, according to CME FedWatch.
The suspense is driven in part by Warsh’s refusal to telegraph what the Fed is likely to do. Warsh has argued that so-called forward guidance is unhelpful, handcuffing officials to forecasts that often fail to become reality.
David Kelly, chief global strategist at JPMorgan Asset Management, doesn’t think inflation today is “sticky” enough to warrant Fed action.
“This is Teflon inflation. It won’t stick. It’ll just slide away, slowly,” Kelly said.
That doesn’t mean prices will revert to the pre-Covid levels that many in the public crave. It would just mean a return to more subtle price hikes, ones that consumers can absorb with fatter paychecks.
“The only way to get prices back down is to cause a recession,” Kelly said. “Affordability can only be achieved by raising income, not lowering prices.”
The-CNN-Wire
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