Hot jobs report makes Fed rate cuts more difficult as Warsh faces policy test

In May, another big jobs report was released, all but eliminating the possibility of a rate cut in the near future, and in the process highlighting the difficulties of new Fed Chairman Kevin Warsh’s policy going forward.

A potential rate cut was already on life support heading into Friday’s nonfarm payrolls report.

But the unexpectedly large increase of 172,000 people, combined with last month’s large upward revision, further weakens the case for policy easing, especially given rising inflation levels and uncertainty surrounding the Iran war.

“If I were at the (Fed), I would say, ‘Look, job growth is good. We don’t need to support the labor market. Inflation is high,'” said Gus Faucher, chief economist at PNC. “So we could keep the federal funds rate at its current level until we get a better sense of what’s going on on the inflation side.”

Indeed, market expectations changed further after the nonfarm payrolls report. Traders priced in an even lower chance of a rate cut at the June 16-17 meeting, raising the probability of a rate hike by the end of 2026 to about 70% near noon Friday, according to CME Group’s FedWatch futures price index.

But Warsh’s dilemma goes deeper than a simple calculation of where interest rates are heading. Many of his colleagues have challenged not just the chair’s position, but also the frameworks and filters through which policymakers interpret the appropriate stance for inflation, growth, and monetary policy.

In recent days, multiple central bank officials have spoken publicly, without mentioning Mr. Warsh by name, challenging some core policy assumptions and positions Mr. Warsh has held since he emerged as a candidate for chairman.

Governor Christopher Waller has expressed concern that consumer and market sentiment is at risk of raising inflation expectations, an important consideration in considering how the Fed should respond.

St. Louis Fed President Alberto Moussallem accepted Warsh’s argument that artificial intelligence and its expected productivity gains will bring inflation to the economy. Rather, Mussallem argued, “it is dangerous to rely on prospects for future productivity growth to solve today’s inflation problems.”

Meanwhile, Dallas Fed President Laurie Logan disputed Warsh’s reliance on “trimmed averages” to combat inflation. These gauges input high and low values ​​into the inflation calculation, focusing on readings near the midpoint of the data.

Warsh said the trimmed average measure shows that inflation is much closer to the Fed’s 2% target than key data indicates, an important consideration at a time when high energy prices are having an outsized impact.

“The changing mix of increases and decreases in prices is pushing the adjusted average down too much, which could result in the adjusted average being below the underlying trend of inflation,” he said in his speech.

What makes Rogan’s comments particularly noteworthy is that her organization, the Dallas Fed, creates the most popular trimmed average, effectively warning against giving too much weight to it. According to the adjusted average for April, the inflation rate was 2.3%, well below the composite index of 3.8% and 3.3% excluding the food and energy core index.

“We are increasingly concerned that we may need to raise interest rates this year to fully restore price stability and properly balance the Fed’s dual mandate,” Logan said.

There were others too.

Governor Michelle Bowman urged the Fed not to overreact to the possibility of temporary price spikes due to energy supply shocks. Bowman also said he was satisfied that the Fed would continue to use the phrase “forward guidance” in its postmeeting statement, and that the market would interpret the next rate cut as a signal that another rate cut is likely.

Mr. Bowman’s position on this language is both a boon and a challenge to Mr. Warsh’s position. He supports lower interest rates, but dislikes forward guidance as an unreliable indicator of future policy.

However, he also cautioned that “the longer the conflict drags on, the more we need to consider the impact on inflation in our outlook.”

Finally, Governor Michael Barr recently addressed Mr. Warsh’s push to shrink the Fed’s balance sheet, arguing that such a narrow focus could do more harm than good.

Mr. Warsh also faces challenges on Wall Street.

The new chairman, along with several White House officials, has looked to the Fed under Alan Greenspan in the mid-1990s as a template for a central bank that saw productivity growth as a counterbalance to inflation to combat an overheating economy.

But Jason Thomas, head of global research and strategy at the influential Carlyle Group, says there’s a big difference between now and then. In a recent note to clients, Thomas argued that real interest rates, or the difference between nominal interest rates and the inflation rate, were much higher under Greenspan, so they were more restrictive then, giving the Fed more leeway.

The argument is essentially that Fed policy back then was tighter than it is now.

“When[The Godfather’s]Vito Corleone asked his assembled guests, ‘How did things get this far?’ That’s the question Kevin Warsh will have to pose to his colleagues when he chairs the Federal Open Market Committee for the first time later this month,” Thomas wrote.

“Do not expect any movement at this or the next meeting. Given the scale of uncertainty created by the closure of the Strait of Hormuz, the value of waiting is too high,” he added. “But it is long past time to abandon the endemic mitigation bias that has been a hallmark of policy for the past two years.”

So, even though Mr. Warsh comes from a group known for its collegiality, he is expected to face a tough challenge if the conference is convened.

Cleveland Fed President Beth Hammack is concerned about inflation and voted against the April statement because it included forward guidance language, but echoed concerns about using a trimmed average and core inflation measure while oil prices remain above $90 a barrel.

“I told you my weight was amazing, but I’m feeling really good right now. My diet is perfect, except for the donuts I had for breakfast and the fried chicken I had for dinner and ice cream afterwards. But other than that, I’m perfectly fine,” Hammack said in a recent public appearance. “Everything has to be taken seriously.”

Hammack spoke of a “conversation” he had with Warsh “a few weeks ago” and expressed confidence that “he approaches the job with a really open mind.”

“I think he’s coming to ask these big-picture questions: What’s working well, where can we do better, how can we support the goals of maximum employment, price stability, and how do we actually make that serve the public,” she said. “I think he is a public servant who will do his best with a big heart.”