Changing Of The Guard

Reflections on Fed policy and beyond, with a lesson from Machiavelli.

Photo by Bao Menglong on Unsplash

Fed Chair Jay Powell will step down in May and Kevin Warsh will replace him, if he gets Senate confirmation. And that’s my excuse for some considerations on monetary policy and beyond.

A matter of style

First: Style matters. It matters as much as substance, because it often shapes substance. The Fed’s press conference is a periodic reminder. There is a reason we have evolved rituals. Care in how we dress, speak and behave reminds us of the significance of an occasion, the importance of what we’re doing or the position we occupy. They are a signaling device: By putting effort in how you present yourself, you indicate that you take your responsibility seriously, because you consider it important — and others should as well. Powell is a sterling example: He speaks with poise and polished language, because he represents a serious institution doing an important job. Sometimes the Fed fails, on occasions spectacularly so; but not because it hasn’t taken its job seriously.

President Trump falls at the other end of the spectrum. His lack of decorum demeans the office, and reinforces the impression that important decisions are taken on the fly. It sets the tone for a political debate dominated by viral insults and devoid of serious discussion. Style without substance is empty. But lack of style can push substance out of the picture.

Machiavelli had developed a personal ritual: After a day of work, before retiring to his study to read the great ancient authors, he would change into his “noble court dress.” Style matters.

Necessary though not sufficient

Second: formal central bank independence is not sufficient for good monetary policy, but it is necessary. Powell attended the Supreme Court’s hearing on the attempted removal of Fed Governor Lisa Cook because it “is perhaps the most important legal case in the Fed’s 113-year history.” After the Department of Justice threatened him with a criminal investigation, Powell denounced it as a crude attempt to influence monetary policy. The Fed’s independence is being tested, and we must hope it survives.

I have argued that fears of a new dovish Fed Chair were overblown. The Fed has always been dovish, and its independence didn’t stop it from monetizing gigantic government deficits, contributing to the 2021-22 inflation spike. I still believe that. Fiscal dominance is a major issue: An irresponsible fiscal policy puts enormous pressure on monetary authorities. Central bank independence is not sufficient for a sensible and reliable monetary policy. But it is necessary. Without it, governments can and will distort monetary policy for political gains. The recent attacks on the Fed are extremely serious and damaging, and we must hope that wiser heads will thwart them.

What next?

Kevin Warsh has strong credentials, and merits the respect of his FOMC colleagues. One source of internal tension might be that in the past Warsh has been very critical of Fed policy, though for the right reasons: he censured the Fed’s failure to contain inflation, its excessive use of Quantitative Easing, its mission creep into climate and social issues, and its habit of surrendering to financial markets’ pressures. He sounded like a hawk, in other words. More recently, he has sounded sympathetic to the Fed’s rate cuts. Critics will suggest Warsh now kowtows to Trump. I think Trump realized that his antics have caused significant damage, and that a purely political choice for Fed Chair would have made matters worse. I hope now the DOJ will take its thuggish threats on Powell off the table, clearing the way for Warsh’s confirmation and clearing the air from these noxious pressures on the Fed.

Nobody can know what Warsh will do until he’s in the job — after all, Trump nominated Powell and then wanted to fire him… Continuity across the board might be too much to expect, given that Warsh has been openly critical of the Powell Fed. My guess is we will see continuity on interest rates and some new thinking on other issues like the Fed’s balance sheet.

I think Warsh is likely to be a pragmatic Fed Chair. He has recently voiced support for lower rates, but in his view, lower rates come in a context where (1) productivity growth accelerates thanks to liberalization and deregulation; and (2) we don’t have large fiscal deficits funded by the Fed. As Warsh wrote recently:

Inflation is caused when government spends too much and prints too much.

Warsh will almost certainly not want to raise rates just to force inflation down by an extra half of a percent. But I doubt he will support further deep rate cuts when inflation shows no sign of coming back to target, unemployment has stabilized, and fiscal policy remains perilously loose.

Speak up!

Speaking of which: I think a central bank should comment forcefully on fiscal policy, when needed. The Fed usually does it with a very light touch, a sentence here and there to characterize the impact of fiscal policy on growth and inflation. Being tactful on political decisions helps preserve the bank’s independence. But when fiscal policy goes off the rails I think a central bank should raise alarm. It might not make a difference. But since fiscal policy is a political decision, it should be a well-informed decision, and the Fed can provide crucial context — to both the government and the voting public.

Warsh has correctly identified loose fiscal policy as the primary inflation risk, and emphasized that government should get out of the way to unleash faster growth in productivity and incomes. Once on the Fed’s podium, he should keep beating that drum.