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Hello and welcome to Notes in the Week Ahead, a JP Morgan asset management podcast that provides insights on the markets and the economy to help you stay informed in the week ahead. Hello, this is David Kelly. I'm chief strategist here at JPMorgan Asset Management. Today's July 27, 2026 no one liked the defendant that much was clear. But when the jury retired to consider their verdict, they hardly knew where to start. The case was so confusing, and the judge's instructions hardly seemed adequate. Perhaps, suggested the foreman, we should start with a list of questions among the five task forces assembled by Kevin Warsh to examine areas central to the the broad conduct of monetary policy, the three eminent scholars assigned to inflation fundamentals arguably have the toughest job the current inflation framework is outlined plainly in the Fed's annual Statement of Longer Run Goals and Monetary Policy Strategy. The Committee reaffirms its judgment that inflation at a rate of 2%, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve statutory maximum employment and price stability mandates. But this begs a list of questions, including should the Fed be targeting CPI or the PCE deflator? Should they focus on overall inflation or core inflation, which excludes food and energy, or some other variant involving trimmed means or trimmed medians? How accurate is inflation measurement anyway, particularly with respect to housing and when considering quality improvements to goods and services? What's so special about the Fed's 2% target? Should it be lower or higher? If the Fed wants to achieve an inflation target, how can they actually do this in today's economy, and what should they be willing to sacrifice to achieve this goal? And finally, what is the inflation outlook from here, and how is it likely to shape Fed policy going forward? The first of these questions is probably the most straightforward. Inflation is commonly defined as the rate of increase in the average price of a broad basket of goods and services purchased by consumers. The Bureau of Labour Statistics, or BLS, has measured this on a monthly basis since the 1940s. The weights assigned to different goods and services are calculated based on consumer expenditure surveys and are currently updated annually. Importantly, the CPI is what's known as a fixed weightless spares index, which means that once you construct a basket of goods and services at the start of a period, you assume consumers don't change their behavior in reaction to price changes. For example, if the price of beef suddenly jumps by 50% relative to the price of chicken, the CPI index assumes that you don't buy less beef and more chicken, and therefore you bear the full brunt of the price increase in the real world. Of course, people do change the consumption patterns, and to assume that they don't results in an overestimate of actual inflation as it impacts consumer welfare. An alternative index known as a fixed weight index, looks at the basket of goods and services bought at the end of a period and works backwards. In this case, if the price of beef soars during the period and you cut back on your beef purchases, the index assumes that you always consumed less beef and so experienced less inflation than with the LE Spares index. But this doesn't account for the fact that you're really forced to consume less beef by the price increase. A chain weighted index such as the consumption deflator takes a geometric average of these two measures and as such it is theoretically a better gauge of the impact of inflation on consumer welfare. There are other differences between the CPI and PCE deflation measures. First of all, the PCE deflator is calculated using data from both the consumer price indices and producer price indices. CPI is also released about two weeks earlier than PCE. The June CPI was released on July 14, while the June PCE deflator will be released this Thursday, July 30th. The CPI applies a greater weight to shelter costs, while the PCE deflator applies a larger weight to medical expenses. However, for purposes of assessing the impact of inflation on the welfare of American consumers, the verdict is chain weighted indices measure changes in consumer welfare better than fixed weight indices, and given this, the Fed has made the right choice in focusing on the PCE deflator rather than cpi. A similarly quick verdict should be returned on the issue of whether to focus on headline, core or trimmed mean or median measures. It's often been noted that core inflation, which excludes food and energy, can give you a better sense of the underlying trend in inflation because it excludes sharp temporary swings in food and energy prices caused by supply shocks. The data support this argument. Over the past 60 years, the average inflation rate has been 4%, both as measured by headline and core CPI inflation. However, while core CPI inflation has ranged from 0.6% to 13.6% year over year, over this period, headline inflation has seen wider swings from minus 2.0% to 14.6%. Of course, food and energy aren't the only volatile CPI categories. Auto insurance, for example, saw huge measured inflation of 22.6% year over year in April 2024 and shows an equally implausible 4% decline over the past 12 months. Measures advocated by Kevin Warsh, such as trimmed mean or median indices published by the Dallas and Cleveland Federal Reserve. Banks can remove temporary anomalies from the data, whether they are coming from food or energy or any other source. But there's a difference between what to look at and what to target. A doctor should measure your weight and investigate your diet and exercise patterns. However, if he wants to protect you from a heart attack, he should probably target your blood pressure in the same way. While narrower inflation measures can provide a better sense of the overall inflation trend, if the Fed's goal is to minimize the harm done by inflation to American families, the Fed should target headline PCE inflation. Before going any further, it's important to address some more micro measurement issues. Overall, there's little to criticize about the scope of the survey used to estimate changes in consumer price indices and consequently most of the personal consumption expenditure deflators. The CPI survey collects Data on roughly 80,000 items each month and since 2004 has done this evenly across all the business days of the month. Nor is there any reason to doubt the professionalism and honesty of the data collectors. However, there are conceptual issues. One of the biggest is shelter, which currently accounts for 35.1% of the CPI basket. One problem with this is the way in which this BLS tracks actual rent paid, which accounts from 7.7% of the of overall CPI. The data are collected using six rotating panels of respondents reporting on changes in rent since they were last surveyed. Since the vast majority of respondents have no change of rent to report, this measure is necessarily lagged and smoothed relative to new rental leases actually being signed. As an example, the June year over year increase in the rental primary residences was 2.8% according to the CPI. But the rent and new apartment leases for the same month range from -1.2% to 1.4% according to private sector surveys. A bigger problem is a 25.7% weight assigned to owner's equivalent rent in the CPI, which showed a 3.3% year over year increase. This measure represents the rent that owner occupiers would have paid if they rented rather than owned the property in which they lived. But since no one actually pays this rent, it's it is hardly an appropriate measure of the cost of living. Monthly average mortgage payments and new mortgages might be better a measure to track, although it necessarily have a tiny fraction of the weight currently assigned to owner's equivalent rent. And like the current measure, it would also ignore the reality that for owner occupiers with either no mortgage or a fixed rate mortgage. A rise in home prices is not an increase in the cost of living, but rather an increase in personal wealth. A second issue is quality improvement. The BLS continues to try to measure the value of new features added to consumer goods, such as adding anti lock brakes to new cars, to exclude these quality adjustments from inflation measurement. Sometimes they can observe the price of an old product being sold alongside a new product with a new feature to make this adjustment. However, most of the time this really isn't practical. For example, if advances in medical understanding make the advice from your primary care physician better over the years, this won't be measured anywhere. A 20 minute checkup today will be assessed to be exactly the same Item as a 20 minute checkup from 20 years ago, and any increase in the price of this visit will be judged to be all inflation and zero quality improvement. For this reason, while many people argue that the BLS understates inflation, the opposite is probably the case. Nevertheless, consumers assume that the progress and the passage of time should normally make a wide swath of goods and services better and consequently don't reduce their perceptions of inflation, even if there's actually some quality improvement in the goods and services they are buying. There is of course much more to be said about the appropriateness and accuracy of inflation measurement. However, to get back on track, Mr. Warsh's committee will also presumably consider the issue of whether the 2% target is appropriate. It's clear that any inflation target should be low. High inflation is generally an economic evil. It boosts business uncertainty and long term interest rates, both of which can discourage investment. And it is particularly loathed by consumers who in general can only compensate for higher prices by demanding higher wages, a task that is very difficult in a world where less than 6% of the private sector workers are in a union and workers have a very unequal relationship with their employers. But if high inflation is bad, then why not target a 0% inflation rate? Actually, there are a number of good reasons to try to avoid this. First, zero inflation, or worse still, negative inflation will tend to slow the pulse of economic activity if you know that hoarding the cash onto the mattress won't result in any less buying power. At the end of the year, you have less incentive to deposit your money at the bank, allowing others to borrow it and thereby fuel economic growth. Second, the Fed may want to stimulate economic growth by lowering the federal funds rate. However, for practical reasons, they can't lower it to below zero percent. And since markets respond to real rather than nominal interest rates, a near Zero inflation rate makes it very difficult for the Fed to stimulate the economy at all. Finally, while American businesses are adept at not granting wage increases, workers generally won't easily accept a wage cut. This means that at times of zero inflation or deflation, firms that are slightly less competitive or out of favor for some cyclical reason end up laying off workers rather than cutting pay, and this behavior can generally exacerbate economic weakness. All of this suggests that the Federal Reserve's goal should be a low and stable inflation rate. In January 2012, the Federal Reserve formally adopted a 2% increase in the headline PCE deflator as that goal. Having done so, there would be a cost to changing it. Reducing it, given that the US has exceeded this target continuously for more than five years would further undermine Fed credibility. However, raising it would seem to be acquiescing to higher inflation, and investors might well question how resolute the Fed would be in trying to limit inflation to 3%, having given up on its attempts to hold it to 2%. All of this argument assumes that the Fed can actually achieve the inflation rate it wants, but this is not true, or at least not true at a reasonable cost. In the short run, there are many things that can lead to a sudden surge in inflation. Inflation in the first few years of this decade were caused by the supply side shortages of the pandemic, a demand side surge fueled by fiscal stimulus, and the additional supply side shock from Russia's invasion of Ukraine. The more recent inflation episode was largely caused by higher oil prices from the Iran war, the the stimulus from obbba, a booming stock market, and tariffs. Very little of the first episode and none of the second could be ascribed to excessive monetary stimulus. There's very little the Fed can do about any of this. There is only one mechanism by which the Fed can reduce inflation, and that is by raising rates to slow economic growth. Moreover, over the years the economy has become less and less sensitive to interest rates as consumers have accumulated cash balances and the economy has become increasingly dominated by services. Consequently, the Fed could probably only get inflation back to its 2% target quickly by putting the economy into recession. And we don't think they'll do that. The Fed meets for the second time this week under the leadership of Chairman Warsh. Since the last FOMC meeting in mid June, data have shown cooler job growth and still subdued wage growth. Gasoline prices have risen, reflecting a resumption of hostilities in the Middle east, and new tariffs have been introduced over the weekend to replace the temporary tariffs imposed on after the overturn of the IPA tariffs. However, while both of these factors should slow the pace of any decline in inflation, we still expect inflation to generally drift down over the next year, reflecting a lack of spending power among lower and middle income consumers and the continued impact of weak demographics in suppressing rents on apartments. As of today, markets are pricing in just a 38% chance of rate increase at this week's meeting. While this is a close call, we think the FOMC will be willing to hold off for a few more weeks to see how events unfold in the Middle East. Thereafter, if oil prices are still rising, the Fed will feel pressure to hike rates to validate its recently tougher talk. However, if some new de facto equilibrium emerges in the Middle east that allows oil once again to flow freely through the Strait of Hormuz and the Bab El Mandeb Strait, gasoline prices should fall back. This could allow the Fed to avoid adjusting interest rates at all this year, sending a positive signal to both stocks and bond markets. Inflation is a choice, as the Fed Chairman is fond of saying, but in truth, it is largely a choice embedded in our current fiscal, trade and Middle east policies. Pushing the economy into recession to try to counteract the inflationary impact of these policies would merely add unemployment misery to to inflation distress. As Mr. Warsh's task forces sweat away over the summer trying to help improve long term monetary policy, they could be forgiven for thinking that their advice might be more valuable, if not necessarily valued, elsewhere in Washington. Well, that's it for this week. Please tune in again next week and if you have any questions in the meantime, please reach out to your JP Morgan representation.
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