Federal Reserve Chairman Kevin Warsh is eyeing up inflation diffusion indices.

At his pivotal speech at Jackson Hole in August, Federal Reserve Chair Kevin Warsh revealed one method he uses to gauge underlying inflation.

"To try to gauge underlying inflation, I find it instructive to disaggregate the 199 individual components of the PCE [personal consumption expenditures] price measure. Over the past 12 months, 54% of goods and services in the PCE basket showed price increases above 3%," said Warsh. He noted that's well below the post-pandemic high of 77% but above the level of 32% in the two decades that precedes the pandemic.

Given that the Fed then went and lifted interest rates three weeks later, the data point clearly has some relevance.

But economists at Nomura led by Aichi Amemiya say the methodology has flaws.

For one, Warsh is treating each component equally, rather than weighting by share of nominal spending.

"That distinction matters. Food, energy and core goods account for roughly 47% of the 199 components on an equal-weighted basis, but only about 32% after accounting for expenditure weights," say the economists at the Japanese investment bank.

Housing, by contrast, accounts for just 3% of the 199 categories despite its 16% weighting in consumption. So Warsh is looking at a particularly volatile subset of inflation categories.

The other issue is that, historically, it hasn't been any better than core PCE inflation in identifying the trend.

As the chart shows, the measures appear to be concurrent rather than lead core PCE price data. "Around major turning points, including the post-global financial crisis disinflation and post-pandemic inflation surge, neither diffusion measure identified inflections in the trend materially earlier than core PCE inflation," the Nomura economists note.

That doesn't mean these diffusion indexes have no value. The team say that in the past, Fed officials including Janet Yellen when she was vice chair, and current Gov. Christopher Waller, have cited diffusion data. The Bank of Canada is among the foreign central banks that track inflation diffusion.

The economists' conclusion is that if Warsh and other Federal Open Market Committee members start putting greater weight on diffusion, it runs the risk of reacting to false signals.

The 2-year yield BX:TMUBMUSD02Y ended Tuesday at its second-highest level of the year.

-Steve Goldstein