With a new chair in the saddle, the Federal Reserve System is navigating through a complicated economy and political environment. At its June meeting, the Federal Open Market Committee (FOMC), the Fed’s policy-making committee, signaled that a policy change was unlikely during the remainder of 2026. This was a switch from prior recent meetings, when the FOMC’s forecasts incorporated an interest rate cut later this year.
The change in interest rate projections was accompanied by higher inflation forecasts for 2026 and 2027. Some of this reflects higher energy prices. However, the forecasts for core inflation, excluding food and energy, were also pushed up. These forecasts appear to have been influenced by some stubbornly high inflation readings in the first half of this year.
These changes in the outlook coincided with the installation of a new chair, Kevin Warsh. Like any new chair, he will be anxious to establish credentials as someone who will set a steady course for the economy and keep inflation close to the Fed’s official 2% target. During his previous tenure as a governor at the Federal Reserve from 2006 to 2011, Warsh established a reputation for being a hawkish inflation fighter. More recently, he has appeared to be more sympathetic to President Trump’s desire for lower interest rates.
The impact of political tensions on the U.S. economy
There is a built-in institutional tension between monetary policymakers and the politicians who appoint them. Federal Reserve officials are appointed to long terms and can only be removed for cause, an arrangement recently reinforced by a Supreme Court decision. In theory, this should allow them to make decisions based upon dispassionate assessments of what is best for the economy and insulate them from political pressures. The markets will be watching to see if Warsh establishes his independence from the White House. Even if Warsh wanted to lower rates, he would have to gain the support of a majority of the members of FOMC.
Although the FOMC signaled heightened concerns about inflation at the June meeting, there are several developments that might alleviate those concerns in the second half the year. Oil prices have reversed most of their earlier increases in recent weeks. This will pave the way for much lower inflation readings. However, the Fed will focus more on non-food and energy prices (core inflation). Interestingly, wage inflation has continued to decelerate even as core inflation has remained stubbornly high. Average hourly earnings for nonsupervisory and production workers in the private sector increased by 3.4% in the past twelve months, ending in June, a significant deceleration from the 4.1% increase seen in the prior twelve months. The graph (below) shows the behavior of this series—with some notable volatility associated with the COVID lockdowns.
Over the five years before COVID (2015-2019), this measure of wage inflation rose an average of 2.9% per year. During the same period, the Consumer Price Index, excluding food and energy, rose by 2.1% per year. It is normal that the CPI shows a rate of increase about 1% less than wages. This reflects the fact that productivity growth offsets some of the higher wages. The ongoing deceleration in wages—to 3.4% in the past year—indicates that there is a good chance that consumer price inflation will decelerate to the 2.0-2.5% range. The Federal Reserve would view this as a desirable outcome, making it unnecessary to tighten monetary policy by raising interest rates.
The Fed can also take some comfort in the fact that inflation expectations, especially in the inflation-linked bond market, have remained subdued. Ten-year inflation expectations are currently at 2.2%, below the level that prevailed in February before the current conflict with Iran began.
The combination of falling oil prices, decelerating wage inflation, and subdued inflation expectations strongly suggests that inflation will decelerate going forward. The FOMC chose to focus on the higher-than-expected inflation readings seen in the first half of this year. But these more forward-looking indicators indicate that their concerns may have been overstated.
