A Little Less Conversation
Elvis Presley has some words of advice for the new Fed Chair.
Watching Kevin Warsh in his second press conference was painful — almost like watching Anthony Fauci invoke the Fifth Amendment over a hundred times in front of the Senate. Both confronted by a rather hostile audience, the two men deployed different strategies, but to similar effect: Fauci said as little as possible; Warsh spoke a lot without saying much.
I’m being flippant. I don’t mean to criticize Kevin Warsh and certainly don’t mean to put him on a par with Anthony Fauci. I don’t expect Warsh will need a pre-emptive presidential pardon.
We just want your reaction function (really, trust us)
In a sense, Kevin Warsh spoke under duress. I had the feeling he would have preferred not to have to give this press conference. At one point during the Q&A, he seemed to indicate as much: he said his predecessors have established the precedent of holding a press conference after every FOMC meeting, and he has committed to maintaining the practice “this year”.
I think this tradition of holding a press conference after every policy meeting should and most likely will be abandoned. The July installment highlighted a very significant challenge for the Warsh Fed: Accountability requires the central bank to provide a high degree of transparency and clarity. We, meaning the public and Congress, have a right to understand how the Federal Reserve interprets the economic and financial outlook and how that factors into its decision-making process. In economists’ jargon, we all want to understand the Fed’s “reaction function”. But as Warsh noted,
When some people that follow the Fed say, well, we don’t want your forecast, we don’t want your ‘dot, ’ we just want your reaction function, part of me hears, what we really want is your forecast, what we really want is your dot1.
He’s exactly right. During this latest press conference, journalists asked him over and over again: Why haven’t you hiked rates yet? When will you hike? What will it take for you to hike?
And here is the tricky part. If transparency means that the Federal Reserve has to explain to us its reaction function and then step by step explain what inputs it’s putting into it, well, then the Federal Reserve would be telling us what it will do next — which is exactly what Warsh says the Fed should not and will not do. The implication, it seems to me, is that we need to move away from a framework where, at every policy meeting, the Fed explains exactly what it’s doing and why.
The transition will not be easy, and it will come with its own set of suboptimal implications. There are always trade-offs. But it looks to me like a necessary change.
Follow the markets (again?)
The press conference highlighted another way in which this shift in monetary policy regime will prove tricky. Fed Chair Warsh noted, with some satisfaction, that the abandonment of forward guidance seems to be working already: financial markets, he said, have started looking at economic fundamentals rather than the Fed, and this explains the upward drift in bond yields across the curve since the June FOMC meeting. Financial markets, in other words, are beginning to process information and provide valuable signals to the Fed instead of reflecting back what the Fed has been telling them.
But here comes the tricky part: during the Q&A, journalists asked, “You said you wanted to hear from financial markets. Financial markets are telling you that monetary policy should be tighter. Why aren’t you listening to them and hiking rates?” This, in my view, reflects a fundamental misunderstanding. Over the past couple of decades, the Fed and financial markets had developed a noxious codependency: on the one hand, the Fed provided ample reassurance and forward guidance; on the other, once financial markets expected the Fed to move in a certain direction, the central bank felt compelled to oblige. The new Fed should break away from both elements of this codependency.
I wish Kevin Warsh had given a clearer and stronger answer, along the following lines: Without forward guidance and without the Fed’s overwhelming intervention in bond markets, financial investors can price asset values and risk more appropriately. They will do this by assessing a range of factors, including economic trends, fiscal policy, potential shocks, and yes, their expectation of future Fed policy. The Fed can then look at market prices and get higher quality signals on, for example, the pressure coming from fiscal policy or the risk differential between investment-grade and lower-rated borrowers, or the market’s assessment of growth and inflation prospects. It can put these signals together with the rest of its information set, carry out its analyses, and come to its conclusions. This is quite different from letting monetary policy be dictated by financial markets, something which has too often happened in the past.
A little less conversation
Like it or not, Warsh has a credibility problem, because he was appointed by President Trump, who said repeatedly he wanted a Fed chair who would lower interest rates. Warsh has set up highly qualified task forces to take a fresh look at data, inflation trends and measures, the impact of innovation, and the effectiveness of monetary policy instruments. This is a laudable and necessary step, given the major changes taking place in the economy and the poor record of monetary policy over the past two decades. The skeptics, however, will suspect he’s just looking for cover to explain away the inflation challenge, bet everything on future productivity, and avoid raising interest rates.
The challenge is compounded by Warsh’s decision to forego forward guidance. A press corps that nodded approvingly as Powell cut interest rates by 175 basis points with a resilient economy and inflation stubbornly above target now aggressively corners Warsh, asking why he is not hiking interest rates, given the resilient economy and inflation stubbornly above target. Warsh could have answered that, as inflation is high but not dangerously so and core inflation does not appear to be rising, the Fed could afford to wait a bit longer to assess the situation, but that a tightening is likely in the cards. Only he couldn’t do this because he has decided to abandon forward guidance.
Warsh is in an invidious position. Given the cloud of suspicion that surrounds him, the only statements that would satisfy the skeptics are policy commitments that he rightly refuses to make. He can only answer with policy moves, and in the meanwhile, it appears communication carries more downside than upside.
As Elvis Presley would advise, a little less conversation, a little more action, please.
It refers to the “dots” with which individual FOMC members indicate where they think the policy rate will be at the end of each of the next three years.
I agree wholeheartedly that the Fed must leave markets to their own devices. Anything that facilitates a one way bet is financially destabilizing.
Great piece, Marco. It triggered a number of thoughts in me.
You mentioned that "(t)he challenge is compounded by Warsh’s decision to forego forward guidance". Well to me, the removal of forward guidance (a sage decision, in my opinion) is what made Warsh's press conference so uncomfortable.
Change takes time. After twenty years and more of forward guidance, I can almost hear the panicked, faltering reactions of analysts and journalists as forward guidance is no longer with us (and this was rather clear in the barrage of journalists' questions you have cited).
The quickest shock-and-awe would be to also forego the press conference ritual, or at least make it less regular, as it once was. The FOMC would then organize a post-meeting press conference only when something has materially changed. This is something that, apparently, Warsh (and you) has in mind already, and this is a good thing. Alas, we are so much used to forward guidance that even the press conference/no press conference announcement could be interpreted as forward guidance: nothing has changed, we continue steady-ahead.
And here comes my criticism (triggered more than the pain and frustration to see Warsh in pain and frustration at this week's press conference): when you commit to ending such a venerable institution as forward guidance, you better have something else to feed the journalists, some other leftover bone for them to gnaw on. Instead, he offered almost nothing, surely nothing substantial enough to replace the dismal 'dots' system — the most cinematic (and quite frankly terrible) invention, yet very 'citable' and 'ppt-able' for journalists.
Perhaps, a solution would have been to maintain forward guidance until the next big Fed's mission — an improvement in the quality of macroeconomic data — was effective in producing effective gauges of where the economy is going. Because, just to be clear, when Warsh says that the market has begun to listen more to the economy rather than the Fed, both the markets and the Fed see a heavily distorted version of it, poisoned by data of infamous quality with large revisions (NFP, for example) or calculation methods that are based on consumption/investment practices of yesteryears (CPI).
Finally, an observation that I repeat here: more attention to drastically reducing the Fed's balance sheet than interest rate action is needed, and urgently so. That would have given a way out to Warsh during the press conference: "the increase in yields is the market anticipating that tightening might come more via curtailing money supply than via interest rate hikes".
As I said, change takes time... so please act now.