Federal Reserve Chairman Kevin Warsh is staring down a rise in inflation that is driven in large part by something the central bank cannot control: the war with Iran.
In this scenario, where prices are rising because of disruption to the supply chain for a key global commodity, the advice to a central banker would normally be to avoid tightening monetary policy. Instead, the Fed should “look through” the rise in inflation caused by soaring oil and gas prices — that is, ignore it — in light of the fact that it does not otherwise appear the economy is overheating. So the Fed should continue holding interest rates steady, rather than hike them.
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The problem for Warsh is that former Fed Chairman Jerome Powell faced a similar scenario as the pandemic waned, notoriously calling inflation “transitory,” and was slow to raise rates in 2021 and 2022. In retrospect, he has been panned for not acting fast enough to hike rates and prevent the worst inflation in decades.
“What’s happening now is similar, but on a smaller scale,” Ryan Young, senior economist at the Competitive Enterprise Institute, told the Washington Examiner.
The latest inflation numbers from the most closely watched inflation gauge, the consumer price index, once again came in hot in May.
CPI inflation rose four-tenths of a percentage point to 4.2% for the year ending in May. That marks the highest annual inflation rate since April 2023. In just the month of May, prices rose 0.5%.
An update to the producer price index this week was even more concerning. In that gauge, inflation lurched eight-tenths of a percentage point to 6.5% for the year ending in May, the Bureau of Labor Statistics reported Thursday.
There are some parallels between today and the wave of inflation that began building in 2021 and ultimately crested at nearly 9% in 2022. At the time, the economy was emerging from a pandemic and grappling with major disruptions to supply chains. Businesses were struggling to keep up with massive changes in demand for goods as families began resuming life as normal. Russia’s invasion of Ukraine then sent oil prices soaring.
At the time, many thought that the rising inflation would merely be temporary, or as Powell said many times, “transitory.” So the Fed waited.
In fact, the Fed still had rates near zero in February 2022, when inflation had spiked to 7.9%. By then, it was too late, and the central bank was forced to drive interest rates up massively over the following years and was still fighting to bring inflation back down to 2% even as this current uptick began.
So that’s a dilemma that Warsh now faces. On the one hand, if he doesn’t hike rates, he could risk causing another big bout of inflation that sticks around for far too long. One the other, if he does hike rates it could be an overreaction to temporary inflation driven by the war with Iran and subsequent energy price increases.
“I don’t have a strong opinion on a rate cut versus hold steady, but I do see the parallels between what’s happening now and COVID,” Young said.
Still, he pointed out there are significant differences between now and then.
For one, the lockdowns associated with the pandemic affected the entire economy, whereas the war is only affecting a portion of the economy through energy prices.
More significantly, Congress pumped trillions of dollars of stimulus into economy in response to the pandemic, juicing demand in 2021 at the same time that the supply disruptions hit.
In 2024, as inflation was waning, Powell said in a major speech that the Fed had been wrong to describe it as purely “transitory,” and that it was caused in part by “overheated” demand stoked by loose monetary policy and high government spending.
Joseph Gagnon, senior fellow at the Peterson Institute for International Economics, said that normally the Fed looks through energy prices because of how mercurial they can be and how the Fed really has no control over them. But he said one concern is that this latest inflation uptick comes after years of too-hot inflation.
“I think the one thing that’s different, maybe a little bit now, is that this inflation comes after we had COVID inflation five years ago, and then last year we had some tariff inflation, and so now we’re having a third round of slightly elevated inflation, and so it does make you worry that people might start expecting it to continue,” Gagnon told the Washington Examiner.
Notably, until 2021, most consumers never experienced unhealthy inflation. The last time it was a major issue was in the 1970s, and many consumers were too young to remember that or were not even born yet.
Gagnon said that inflation expectations might be a point of concern.
“This is the other difference that is a reason to worry, because if people keep seeing inflation exceeding the target year after year for different reasons, they might draw a conclusion that this is just a new world forever,” he said.
The Fed board is set to meet for the first time under Warsh’s chairmanship later this month, when it will decide what to do with monetary policy. Most investors expect the Fed to hold rates steady, but Warsh’s remarks and speeches after the meeting will be closely scrutinized.
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The Fed has a dual mandate, namely to ensure both price stability and full employment. Because the jobs market is relatively strong, it’s likely that the Fed under Warsh will be more focused on the inflation aspect of that mandate.
“It’s more they’re trying to balance a tightrope between the economy slowing down a little bit, inflation is high. Do you raise rates, or do you cut them?” Young said. “And I think the Fed is right to prioritize inflation, so that pushes them towards either holding steady or raising rates.”
