Hottest Inflation Report In 3 Years Has One Big Problem

We're telling ourselves that it's transitory, like we said a few years ago. We're telling ourselves, 'Oh, it's just for now. It's fake inflation. It's just for now. It's just the fuel because the Strait of Hormuz is just blocked up for the time being.' I'm not sure I believe that anymore. And it starts to seem as though the 3.8 number could be something that lasts for a very long time. And I wonder if that would have a structural effect on the economy and potentially on markets as well. And I have a memory that at the very start of the war I came on your show and I said there's a long history of excess optimism at the beginning of wars, that a more realistic assessment should be that it was likely to be far longer with a far greater economic cost.

Ed, just hearing you go through those numbers caused the worry lines to etch a little deeper right now. And I was in a good mood before I started talking to you. Two things are true. This is a high inflation read. The cost of living is rising. It's rising sharply. People are finding it hard to keep up. The affordability crisis is real. The second thing that's true is none of this is yet deeply problematic. So let me back up and point that out. There's two inflation measures you just pointed to, Ed. One was headline inflation. That answers a specific question: if I care about the cost of living, what happened to the cost of living? That's it. It rose. And so if you feel like you're not keeping up, the truth is when you're paying four bucks a gallon, you're not. Second question is what's going on with the future of inflation? And that's where economists tend to look at core inflation. We exclude food and energy. Food goes up and down with droughts and avian flu and stuff like that. Energy goes up and down with strife in the Middle East. And so neither really capture the underlying inflationary momentum or the inflationary psychology. And that at 2.8% is slightly uncomfortable but not miserable. And a question, and perhaps the question over the next few months, is how much will we be able to keep this as an energy crisis, Iran, temporary story — remember there's still some tariff business going on — versus how much does it gain its own momentum, start to feed its way into inflation expectations, and become something substantially more to worry about, because getting inflation down from 3% to 2% would require slowing the economy quite substantially.

The only thing that matters when I'm talking about Iran, they can't have a nuclear weapon. I don't think about the American financial situation. I don't think about anybody. I think about one thing: we cannot let Iran have a nuclear weapon. That's all. That's the only thing that...

Actually, I thought it was going to be much worse. So, what a relief. Look, let me start by agreeing with the president. I think it's probably immoral to go to war in order to deliver low gas prices. I don't want him to walk around doing that. I think the stakes of war are so much larger. They're human. Gas prices are narrow, small, short-term, and selfish. What I noted, though, is the mission changed, which is originally we were going in there to free the Iranians from the yoke of oppression. All we wanted was regime change, and we did in fact get rid of Ayatollah Khamenei, which is why we now have instead Ayatollah Khamenei. I understand there's a vast difference between the two. Scoring this war is so damn difficult because the president refuses to say why we're there. Having said that, it's okay for him not to be laser-focused on what this does to the cost of living for Americans. Let me come back and give the other side of that. You know, partly because I do think the stakes — if we're talking about the freedom of 90 million people or the possibility a crazy regime may bomb us to smithereens — those stakes are just enormous. And I'm happy to pay a little more at the pump if those are what we achieve. I want to be clear: so far we've achieved nothing, right? At the start of the war, the Strait of Hormuz was open. We had Ayatollah Khamenei and the Iranians had nuclear material. The Strait of Hormuz is closed. They have Ayatollah Khamenei and they still have nuclear material. So whatever the — I don't feel any sense of why my life's better here. I think the reason people have a right to resent this is the president never tried to make the case to the American people: here is an important and noble goal from which I'm going to ask sacrifice. He seems constitutionally incapable of asking for sacrifice. Sacrifice is a thing that populations do when they're considering war. That's an adult, grown-up, mature conversation. Just like saying, 'I'm going to start a tariff war and prices aren't going to rise' is an immature lie. You might think there's a serious argument to be had about defending American manufacturing or some argument — it's not my argument — there'll be some costs and there'll be some benefits, but I think this leads to a better world. That's a mature conversation. Not even having the conversation before putting Americans' prosperity, livelihoods, and in some cases children at risk. It's not my way of doing things, man.

And I have a memory that at the very start of the war I came on your show and I said everything that economic theory and history tells me is that there's a very large risk this takes a lot longer than four to five weeks and almost no chance it takes less, and that there's a long history of excess optimism at the beginning of wars, and that a more realistic assessment should be that it was likely to be far longer with a far greater economic cost.

I take no great pleasure in being right. I just want to remind you I was... food and energy. Let me say two things about it. One, you know, we take it out for the reasons I described earlier, which is if you want to — we leave it in for the reasons I described. If you want to describe the cost of living, it's gone up. Americans are sacrificing. If you want to know what's happening to inflationary psychology, we take it out. But there's a very real risk it spills over and becomes part of the process. And that's very much what's on the Fed's mind right now. That in our models, people shouldn't think about inflation — should think about inflation coming from energy differently from other things. From reality, they may not, particularly after several years in a row of inflation being above the Fed's target. And finally, this wasn't the question you asked, but I do want to put it in there. Food and energy is something we look through as part of a statistical exercise. I want to predict inflation. What are the most persistent aspects? Blah, blah, blah. But food and energy are also a very large part of the consumption basket of the world's poor. And so the World Bank and the IMF have pointed out if you wanted to think about who's really going to be hurt by high food and energy prices, it's actually the most vulnerable in the world.

Right? And again, if we could have a mature, responsible conversation about whether or not to go to war, part of that — one hopes the American conscience cares somewhat about hunger and poverty beyond our shores. And the consequences there are very large. And you and I so far have been talking about the United States economy, and it's worth remembering that the US economy is actually much less affected than many of our allies, and that Europe and Asia are feeling much, much, much more pain than we are. And those folks, even more than the American people, weren't asked their feelings about this either.

I agree with that. So look, here's the glib answer. The glib answer is the stock market's at an all-time high. Therefore, the market thinks the war is fine. That's glib because markets reflect lots of things. So let's think about it in a more focused way. Let's say that the market's partly responding to the war, partly the AI boom, and partly other stuff. And if what you want to do is take the market's response as a vote of confidence in the war, then what you need to do is isolate the part that's due to the war. How might we do that? Well, one answer is we can look every single time that the president has been more belligerent and pushed into the war. Markets have fallen literally as he speaks. Every single time he steps back and looks like he might back off, markets rise. So that's markets saying they believe — they're acting as if they believe that American large companies will be more profitable over the longer run if the president would have stepped back from the conflict rather than stepping into the conflict. You could actually go even a step further and try and quantify this. So if only we had some index of trouble being caused by the Middle East, then what we'd do is we'd see how that index was correlated with the stock market. I don't have the perfect index, but I got a pretty good one, which is oil prices.

All the movements up and down in oil prices are about is there more trouble, more strife, are we moving towards war or not? And it turns out on a day in which oil prices rise 10%, the S&P 500 falls by 0.9% on average. You just draw a scatter plot and you'll find that. You can get fancy and call it a regression coefficient. And so that tells you there's very strong, statistically significant evidence that whatever it is that's driving oil prices up and down — and we know what it is — has big negative effects on US stocks. We also know that the oil price is up about 60 or 70% over the course of the war. And so if you want to extrapolate my point negative 0.9 coefficient, that says you take the 70% rise in oil prices, multiply by minus 0.9, and you can say that US stocks are about 6% lower than they would otherwise be — at 6.3% — as a result of this war. And then I'm just going to be conservative and round that down to 5%. So I think this analysis is very back of the envelope, but we're in the middle of a war. No one's giving you strong answers. You know, I'm not going to defend it till the day I die, but I think it's informative. This says that US stocks are five percentage points lower as a result of the president's aggression so far.

So, the most important question is who is Kevin Warsh?