Warsh's Biggest Challenge at the Fed: Maintaining the Fed's Credibility

Kevin Warsh returns to the Federal Reserve as the new Fed Chair. His return occurs at a crucial time for the Federal Reserve, as its independence has been threatened multiple times over the past year. However, Mr. Warsh's greatest challenge may be preserving the Fed's credibility.

Mr. Warsh joins the Fed with controversial views on inflation measurement. Mr. Warsh advocates that policymakers move away from conventional inflation metrics and instead focus on "trimmed averages." This approach excludes the "tails," or the items with the highest and lowest price changes in a given month.

"Trimmed" inflation-like core measures are attempts to remove price outliers from the rest. However, inflation cycles are not linear; they include outliers and the composition changes over time.

But any effort by the Fed to alter the targeted measure would damage its credibility, as investors and analysts recall the Fed's actions in 2020.

In 2020, addressing criticism for consistently falling short of its 2% inflation target, the Fed introduced an "inflation-averaging targeting" framework. This approach would allow inflation to surpass the 2% mark to compensate for times when it was below target.

During the five years before inflation-averaging was implemented, the personal consumption core deflator was below the target in four out of five years, averaging 40% under the target. Meanwhile, the consumer price index exceeded the target in three out of those five years, averaging just under 2%.

However, over the past five years, inflation trends have notably reversed, with both the personal consumption deflator and the consumer price index averaging several hundred basis points above the 2% target. This trend persists in 2026.

If the Fed opts to alter its inflation target while inflation is significantly above the target, especially after modifying the framework to promote more inflation and persistently low official interest rates when inflation was below target, it would set a bad precedent. Critics would argue that the new Fed Chair is adjusting the inflation target to squash calls for a rate hike, while opening up the possibility of an official rate cut later, which is what President Trump is seeking from his nominee.

Credibility is built by consistently following its mandate without retreating or changing targets, which can falsely suggest that you are taking the necessary actions to control inflation.

If Fed Warsh urged the FOMC to implement a new inflation target, he would risk significantly damaging both his and the Fed's credibility. Additionally, the bond market would strongly express its disapproval by substantially increasing long-term interest rates. What choice will Fed Warsh make: satisfy the individual who nominated him or prioritize the most important people, the investors?