The inflation conundrum
During his February 16, 2005, Congressional testimony, then-Federal Reserve Chairman Alan Greenspan coined the term “conundrum” to qualify the decline of long-term interest rates while the Fed was actively hiking.
This economic anomaly seemingly decoupled the Fed’s traditional monetary policy from the broader bond market, confusing policymakers and economists alike.
The current unusual decoupling of core inflation from trimmed-mean inflation, Kevin Warsh’s preferred inflation indicator, is also confusing and is fueling a critical debate about what is the “true” core inflation rate?
Trimmed mean inflation is a measure of inflation that drops the biggest price movers (both spikes and plunges) before averaging the rest.
For the Dallas Fed trimmed-mean inflation rate, 24% of the weight from the lower tail and 31% of the weight in the upper tail are trimmed. “Those proportions have been chosen, based on historical data, to give the best fit between the trimmed mean inflation rate and proxies for the true core PCE inflation rate.”
Warsh’s preferred indicator was designed and weighted to closely mimic the indicator most people watch!
Between 2010 and 2020, trimmed-mean PCE inflation ran slightly higher than core PCE inflation. Not only has it been lower since, but, since October 2026, trimmed-mean inflation has slowed from 3.4% YoY to 2.4% while core PCE inflation accelerated from 3.4% to 4.3%.
Many economists conclude that, since the “belly” of inflation is slowing, the true trend is down.
Mechanically, when tails are small and symmetric, trimming has limited effect; the trimmed mean is then primarily the average of the “middle” categories, which were often running a touch hotter than aggregate headline because some goods disinflation (China, tech) pulled headline down like in the 2010-20 period.
The post‑pandemic period looks structurally different:
-
Price‑change distributions for PCE became strongly right‑skewed: a relatively small set of categories (durable goods like new/used cars, certain services, fees) experienced very large increases, while many others moved more modestly.
-
The Dallas Fed procedure trims off a large fraction of the upper tail; with skewness, that means it systematically removes more upward pressure than downward pressure, biasing the trimmed mean downward relative to the true underlying trend.
Cleveland Fed work quantifies this: when the cross‑section of price changes turns more positively skewed—as it did after 2021—both median and trimmed‑mean inflation show a time‑varying bias, typically understating trend by tens of basis points unless adjusted for skewness. That’s why since roughly 2021–22, trimmed‑mean PCE tends to run meaningfully below core PCE and often well below headline.
Why the sharp divergence since last October:
This informative Dallas Fed chart “plots the evolution of the distribution of price increases in the monthly component data over the past year. The chart shows the percentage of components each month, weighted by their shares in total spending, for which prices grew between 0 and 2 percent (at an annual rate); between 2 and 3 percent; between 3 and 5 percent; between 5 and 10 percent; and more than 10 percent.” It illustrates what percentage of consumer spending is experiencing low, moderate, or extreme price increases.
The vertical axis (Percent of Expenditure) shows the cumulative share of the total PCE consumption basket.
The colored bands only stack up to roughly 70–80% of total expenditure. The white space remaining at the top (my black rectangle) represents components experiencing negative price growth (deflation, or less than 0%).
The bands segment price growth by severity, ranging from optimal/low inflation (Purple: 0–2%) to extreme inflation (Green: More than 10%).
The Dallas Fed automatically cuts the lowest 24% of price changes. Looking at the chart, this means the white deflationary zone at the top and a sliver of the purple (0–2%) band are systematically discarded every month.
The Fed also cuts the highest 31% of price changes. This means the entire green band (More than 10%), the entire blue band (5–10%), and a portion of the orange band (3–5%) are stripped away.
The Trimmed Mean inflation rate is calculated only from the remaining middle section—predominantly the cyan (2–3%) band and most of the orange and purple bands.
We can observe that, since November 2025, a growing share of spending is in categories with >3% annualized monthly inflation, but many of the very fastest‑growing categories lie in the top 31% of the distribution and get trimmed out.
Recent research from the Dallas and Richmond Feds argues that the fixed 24/31% cutoffs can produce downward bias when positive skew and global supply‑side shocks dominate, exactly like the current environment.
So, since last October, headline/core PCE are being pulled up by a relatively narrow cluster of high‑inflation components, while the trimmed‑mean algorithm is stripping much of that out and averaging a middle that has not moved as much. That produces a falling or flat trimmed mean against a rising core/headline.
Without adjustment, trimmed mean is now a biased low estimate of trend, especially in periods when skewness spikes.
In reality, inside the trimmed regions (the belly), a lot of categories have moved from “moderately hot (2-3%)” to “hot (3-5%)” so the belly has actually fattened as my red arrows show, with a larger part of it being 3-5% inflating, which has not (yet) been reflected in the trimmed-mean series.
The Cleveland Fed calculates its own 16 percent trimmed-mean CPI, “a weighted average of one-month inflation rates of components whose expenditure weights fall below the 92nd percentile and above the 8th percentile of price changes.” A symmetric and substantially less radical trim. The May data show Core, Median and Trimmed-Mean inflation all at 2.9% and rising.
Kevin Warsh is closely watching an indicator that two Federal Reserve Banks say is flawed, currently downwardly biased by global supply-side shocks, and thus not reflecting the reality. An indicator that for 10 years prior was actually consistently somewhat higher than core inflation.
Mr. Warsh is way too smart not to know this …
Another Federal Reserve bank, The Richmond Fed, found that a panel of 530 CFOs ranging “from small operations to Fortune 500 companies across all major industries” said that their most pressing concern was inflation (25% in Q2 vs 9.5% in Q1), particularly non-labor costs.
CFOs are seeing inflation in real time which Ed Yardeni illustrates with these charts:
Hopefully, ceasefires, a mild labor market and potential AI-productivity will combine to quickly stop the build-up in price pressures throughout the pipeline. Yes, everything energy-sensitive will deflate in coming months, but watch the belly.
Because inflation matters, more than most investors think. Whatever his bias, Kevin Warsh was quite clear 2 weeks ago: “This committee will deliver!”, even though the almost same committee has not delivered for 5 years.
It matters particularly when valuations are very stretched …
… on profits boosted by spiking margins …
… leading analysts to project LT profit growing 25.5%, even faster than 2000’s 19.5% expected growth rate (actual was 5.5%).
Analysts currently forecast S&P 500 earnings rising 26.6%, slowing to +17.4% in 2027 and to 13.1% in 2028 (I know, doesn’t jibe with the 25.5% LTEG above, but still 18.6% CAGR, the very high end of history).
FYI, only 4 sectors (Energy, Materials, IT and Comm. Services) are growing earnings faster than the S&P 500 average this year. The other 7: +9.1% on average.
For 2027, only 3 sectors (Health Care, Industrials and IT) should be growing earnings faster than the S&P 500 average. The other 8: +7.3% on average.
Inflation also matters when leverage is unsuspectedly high.
The Trillion-Dollar Borrowing Binge Lifting the Stock Market to Risky Heights Leveraged funds and margin debt have grown to unprecedented levels this year
Investors have never been more eager to ratchet up their stock returns through margin loans and funds that amplify gains and losses. It may be a sign of trouble.
U.S. margin debt, or what investors borrow from their brokerages to buy securities, rose 54% to a record $1.4 trillion in May from a year earlier, according to Finra data. Meanwhile, high-risk leveraged exchange-traded funds that produce double or triple the daily move of underlying stocks are growing rapidly, as is trading in options tied to them.
The risks surfaced this past week in South Korea, a market dominated by highflying semiconductor stocks and rife with investors eager to pile on leverage. Korean stocks gyrated, triggering circuit-breakers meant to stop losses on the way down. As the souring mood spilled into U.S. trading, hitting AI-related stocks, a chorus of investors and analysts sounded the alarm that leverage was building up here, too.
“I’m fearful that we’re building unintended leverage that isn’t fully understood,” said Mark Hackett, chief market strategist for Nationwide’s investment management group. “You’ve got people with a lottery mentality using margin to buy options on levered ETFs. That’s three or four layers.”
Buyers ranging from hedge funds to teenagers on Robinhood have poured money into leveraged ETFs this year, helping to nearly double the assets in these funds to a record $220 billion between March 30 and June 3, according to FactSet. (…)
The risks of buying leveraged funds are well-advertised: a 30% drawdown in the underlying stock can turn into a 90% wipeout for the fund. But Wall Street sees a broader problem emerging: These funds, along with other forms of leverage, can also affect how the individual stocks behave. The recent action in South Korea, market participants said, offers a glimpse at the risks.
In a bid to keep pace with the flow of new money, leveraged funds have bought some $300 billion in derivatives linked to single stocks and indexes since the end of March, Barclays analysts estimate.
Those purchases have in turn spurred demand for underlying shares from market makers, which buy stocks to hedge their exposure to the derivative contracts they write.
That’s almost certainly contributed to the sharp gains in corners of the stock market this year. But when stocks fall, leveraged funds lose assets. That forces them to reduce exposure to the shares they track, which in turn threatens to pull down stock prices even more. There is a danger, market analysts said, that this cycle can quickly spiral into heavy losses.
“That’s a somewhat terrifying figure to contend with should it need to be unwound in a short period of time,” Alexander Altmann, global head of equities tactical strategies at Barclays, told clients on Wednesday. “This is without a doubt the largest nondiscretionary driver of risk at the moment.” (…)
“I am genuinely worried we have so much money going into the complex of leveraged single-stock products because the more money that goes in there, the more this procyclical trading effect happens,” said Dave Nadig, an industry veteran and director of research at ETF.com. “Anytime you have any known-in-advance, price-indiscriminate buyers and sellers, you have a problem.” (…)
South Korea’s top financial regulator said earlier last week that he regretted not blocking the launch of leveraged single-stock funds.
“These are high-risk products, and it seems like about 92% of holders are retail investors,” Financial Supervisory Service Gov. Lee Chan-jin said at a press briefing. “Despite consumer warnings, trading hasn’t cooled.” (…)
This can explain some of that:
The Lag-7 (Callum Thomas)
The divergence widens —Mag-7 is increasingly being rebranded as the Lag-7 as Mag-7 dropped -14% from the 14th May peak (vs ex-Mag-7 up +5% over the same period). But note that tick-up from oversold levels on Friday.
@neilsethinew
- FYI
(Koyfin)
“We the People”
Bruce Mehlman writes that
402 of 435 House seats are not competitive. While the nation is almost evenly divided, fewer than 10% of Congressional seats are close. Thanks to aggressive gerrymandering, geographic self-sorting and winner-take-all general elections, the winners of partisan primaries are all-but guaranteed to capture >90% of seats. What happens to a system designed for competition-driven-compromise when there’s so little competition?
But is the nation so evenly divided? K-shaped politics!
Yes, the number of Democrats and Republicans the same at 27% but declared “Independents” are now 45%, up from 35% 20 years ago.
The Constitution says nothing about political parties, which are neither required nor preordained. Yet the Republican & Democratic parties have dominated U.S. politics for most of the past two centuries.
Registration data suggest voters are increasingly frustrated by the status quo but unable to change much given rules entrenching the duopoly (partisan primaries; winner-take-all districts).
If 45% of voters don’t want to be Democrats or Republicans, should 99% of Representatives be Democrats & Republicans?
Money rules America.
Campaign cost are increasing much faster than inflation, with the richest Americans increasingly dominating election finance. Does this make our democracy more robust & resilient, or does it undermine trust, accelerate alienation & drive populism?
In my December 23, 2025 post Ten Days In China: Who got a plan?, I discussed China’s obsession with long-term planning:
- Five-Year Plans provide 5-10 year stability. Goals persist across leadership changes, allowing for long-term R&D investments.
- The US approach historically avoids broad, “socialistic state-led” industrial planning. Instead, it uses the capitalistic “market-correction” mechanisms to nudge the private sector.
- The government sets broad goals and offers incentives for private companies to figure out the solution. It relies on private competition to determine winners.
- US policies are generally legislated or, increasingly, set by presidential decrees that can be altered by future administrations. They lack long-term guarantees and in the case of decrees are often reactive rather than thoroughly planned, analyzed and discussed.
Bruce Mehlman again: Can America Plan Long-Term When the Rules Keep Changing?
Every two years the partisan alignment in Washington changes. Republicans cut Democratic projects when they’re in charge, while Democrats end GOP initiatives when they’re in control. Congress hasn’t funded the government on time since 1997, governing mostly by short-term stopgaps…
Administrations operate via regulations and executive orders that get tossed by courts & successors. How can businesses (or federal agencies) plan & invest for the long-term when rules & incentives keep flip-flopping?
Europe’s Heat Wave Is the Worst on Record, Researchers Find
Researchers at World Weather Attribution, who looked at heat and humidity levels during both the day and night during three consecutive days in the month of June, found that temperatures were between 5C and 12C above the seasonal averages across France, Germany, Italy, Spain and southern England. (…)
“Yes, this is climate change,” said Friederike Otto, a professor at Imperial College London and a co-author of the study. “Yes, it’s us, no, it’s not El Nino, yes, we have the solutions, no, we’re not implementing them fast enough.”
The current heat wave is now shaping a “structural investment trend,” Sarah Kapnick, JPMorgan Chase & Co.’s global head of climate advisory, said in an interview with Bloomberg Television on Friday. “The stresses that we see today are only going to get worse because heatwaves like this ten years from now will be over 40C and it will keep going.” (…)
Lucy Kloc, a Floridian living in the U.K., used to make fun of her British boyfriend for complaining about the summer heat. How bad could it be, the Jacksonville native thought? She’s endured humid, 90-degree-plus summers most of her life.
“Before, I was like ‘This is nothing, you’re just being a weenie about it,’” said Kloc, who moved to Manchester last year. Now sweating her way through a record-breaking heat wave, Kloc is ready to admit that she was wrong.
“I really did think they were just being dramatic, that it can’t be that bad,” she said. “But it is.”
Americans in Europe have been getting the shock of their lives this summer as temperatures soar to new records across the continent. (…)
“I did get humbled,” said Marissa Parks, a 30-year-old nurse who moved to London last year from Houston. “Being a Texan, it feels kind of embarrassing to be in London and be like, ‘I can’t handle the heat here.’” (…)
“These heat waves hit different,” she said. “You can’t get any reprieve from it. Once you do get hot, you stay hot.” (…)