By Howard Schneider
WASHINGTON, Oct 30 (Reuters) - New data may challenge Federal Reserve Chairman Kevin Warsh's sense that the US economy can handle a robust expansion without stoking inflation, as a key measure of price pressures jumped and strong consumer spending and business investment pushed growth further beyond the level most central bank officials see as sustainable.
Warsh, speaking on Wednesday after the Fed decided to hold interest rates steady, said he did not think the economy was "too
hot," and that he did not want "to throw sand in the gears" of an expansion that has been gaining steam on the back of investment in artificial intelligence and consumer spending that continues to grow despite tepid gains in income.
The jump in third-quarter gross domestic product, announced on Thursday by the US Commerce Department, however, was even faster than anticipated, with output growing at a 3.4% annualized rate in the July-September period, consumer spending rising by a robust 3.8%, and investment in business equipment up a massive 20.9%.
The pace may not continue. Consumer spending, for example, grew faster than income in the recent GDP report, a situation some economists said was unlikely to last, and Warsh said on Wednesday that a recent tightening in credit markets showed investors had become "more discerning in their capital allocations," a possible precursor to slower investment growth.
But the data in hand still show an economy that so far has not slowed despite the outlook for tighter monetary policy, with strong demand now coinciding with broad-based inflation.
Different measures of inflation's breadth show anywhere from roughly 50% to nearly 60% of the items in the Personal Consumption Expenditures Price Index, the gauge the Fed uses for its 2% inflation target, posting annual price increases of more than 3% in September — far above pre-COVID-19 norms for a measure Warsh said he sees as a good indicator of underlying inflation trends.
Though the number of items above that 3% level fell slightly last month, Diane Swonk, chief economist at KPMG, said the details of the PCE report showed inflation was broadly persistent across the economy, particularly in service industries where Fed rate hikes may have less of an impact.
The PCE Price Index rose 3.6% in September after a 3.4% rise in the previous month, pushing it further away from the recent low of 2.3% in March 2025, near the start of President Donald Trump's second term in the White House.
Swonk said that while she felt Fed policymakers should have raised rates this week, she understood the motivation to be patient because "they don't want a recession for 3% to 4% inflation" if they could tackle the problem more slowly and keep the current expansion going, a goal Warsh himself laid out during his press conference.
"That said, it is not clear you can just cool things around the margin, given inflation is getting very sticky," Swonk said. "The Fed is looking behind the curve," particularly with financial markets now anticipating two to three more rate hikes, and tightening financial conditions on that basis.
Warsh noted on Wednesday that the credit tightening is in line with Fed expectations, and the very thing he felt would help return inflation to target.
But "that is sand in the gears," Swonk said. "Why has there been tightening? They expect more rate hikes ... You have to deliver on that."
'THE MOST OPTIMISTIC PICTURE'
The US central bank's 10-2 policy vote on Wednesday included dissents from Fed Governor Lisa Cook and Cleveland Fed President Beth Hammack, who said they favored raising rates now. The Fed's next meeting is scheduled for December 8-9, with markets putting roughly 80% odds on a quarter-percentage-point increase at that session, with further policy tightening expected next year.
Warsh on Wednesday said he was reluctant to describe the economy as "too hot," in part because, he argued, it is hard to estimate its noninflationary rate of growth, particularly at a time when productivity gains — from artificial intelligence or otherwise — may be improving the supply side of the economy.
"We never know what potential growth really is," Warsh told reporters. "We can't measure it precisely. ... Economic growth is higher. But that doesn't tell me that economic growth is somehow causing inflation and making our job harder."
The 3.4% annualized growth registered in the third quarter, however, if sustained, would far outstrip even the most optimistic Fed official's sense of the long-run growth trend, a figure premised on inflation held to the central bank's 2% target. In policymakers' economic projections released in September, the highest estimate of long-run growth was 2.5%, with most policymakers in the 2%-2.2% range and a median of 2%.
"He (Warsh) is clearly trying to paint the most optimistic picture both for the economic expansion and the leverage the Fed has" to lower inflation, arguments that, if true, would mean the Fed could get by with fewer rate hikes, said Vincent Reinhart, chief economist at BNY Investments and a former head of the US central bank's monetary affairs division.
Reinhart feels the Fed will have to raise rates two more times, but with risks "decidedly to the upside," particularly if the benchmark global oil price remains around the current level of nearly $115 a barrel, forcing a steady round of adjustments in other industries.
Even if Warsh is correct that AI investment proves susceptible to rate increases, the Fed may still have to cool demand to meet its inflation goal, Reinhart said.
The large US services sector, for example, is "just trundling along and will adjust only slowly," he said. "If you really want to make faster progress on inflation, you are going to have to work harder on demand to get the stuff that can adjust to adjust quickly."
(Reporting by Howard Schneider; Editing by Paul Simao)
