Sometimes innovation starts with going back to basics.
Fed Chair Kevin Warsh is bullish on innovation, particularly on artificial intelligence and its potential impact on productivity and growth. He has set out to overhaul the way the central bank runs monetary policy: he wants to gain a better understanding of how digital innovation will change the economy and the transmission of monetary policy; and he wants to leverage innovation to improve the quality of data and economic modeling that the Fed relies on.
In his Jackson Hole speech, however, the emphasis was on going back to basics, on restoring orthodoxy.
Remember when…
He opened with a reminder of why policymakers should always remain open-minded and humble: not so long ago, economists and policymakers talked only of secular stagnation and the global savings glut. “All the good stuff had been invented,” and we were condemned to an eternity of slow growth, with capital sitting on the sidelines for lack of attractive investment opportunities. Today, the opportunity to invest in AI appears so attractive that there is barely enough capital to feed it.
I think enthusiasm for AI is excessive, and Secular Stagnation proved misguided well before large language models came onto the scene, but the juxtaposition was a very effective way to make a very important point: policymakers should resist the temptation to claim that the world has changed in such a fundamental way as to justify jettisoning common sense. Hopefully, Warsh will keep that in mind as he gazes upon the shining potential of AI.
Money matters
Warsh also argued that “money matters:” The money supply created by the central bank and by the banking and financial system is a key determinant of prices and financial conditions. Warsh acknowledged that this view “is not fashionable these days,” and his decision to restate it was all the more remarkable given that the central theme of this year’s Jackson Hole conference was the impact of innovation on the economy and the transmission of monetary policy. He also stated that interest rates are the predominant monetary policy tool and that any unconventional measures should be used sparingly and only in emergencies — a reminder that he’d like a smaller Fed balance sheet.
Boxed in
Financial investors wanted Kevin Warsh to provide greater clarity on the conduct of monetary policy under his stewardship — they wanted the Fed’s reaction function. Warsh smiled and sort of said, Ah, well, if only we understood the economy well enough to have one… Which is a fair point.
At the same time, though, he painted what to me seems a clear-cut case for tighter monetary policy: (1) the Fed today should focus squarely on inflation, which remains stubbornly above target while the labor market is at full employment and the economy continues to show resilience to shocks; (2) there is no evidence that underlying inflation is coming back to target; (3) a look at financial markets suggests that financial conditions are not tight; (4) the Fed bears responsibility for five years of excessively high inflation that has damaged workers and consumers; unless it becomes persuaded that inflation is coming back to target sufficiently fast, it must act.
It’s not a reaction function. It’s not — God forbid — forward guidance. But it’s a pretty strong indication that, barring very positive surprises on the inflation front, the Fed will hike rates — or Warsh will have some serious explaining to do.
Cage fight
This return to monetary policy orthodoxy sets up a cage fight with the Treasury. Last week I noted that unless the government can get its fiscal house in order, one inevitable consequence will be even more fiscal dominance — greater pressure on the Fed to help keep borrowing costs down. But at Jackson Hole, Warsh reiterated his distaste for quantitative easing and forward guidance, his desire to see unfettered market pricing of financial instruments including U.S. Treasuries, and his commitment to bring inflation back to target.
Monetary policy needs to tighten. Fiscal policy seems set to get even looser. The two are on a collision course. Someone’s gonna get hurt.
Kevin Warsh has his work cut out for him. As Bruce Springsteen sang:
“Are you tough enough to play the game they play / Or will you just do your time and fade away / Down into the Jackson Cage.”
Hi Marco. I agree with you that Warsh's speech ticked all the right boxes. To me, it was especially about refuting dangerous ideas such as secular stagnation and blind investment into AI. However:
1) This is Jackson. It's a place where central bankers can calmly express their beliefs (on monetary and fiscal policy, on how being hawkish or dovish differs from forward guidance, and everything else). FOMCs are different setups, where Warsh needs to find consensus across the whole board, the composition of which is far from one where everyone thinks as clearly as Mr Warsh.
2) I appreciated his point that we don't need a rule because we don't know enough about how monetary policy works and about data quality. So let's focus on this first, especially data quality. It's ridiculous that we have Claude & friends and still think that the way CPI/PPI, PCEs, etc., are computed provides an unbiased, broad measure of price pressure. There isn't one price for milk, one for strawberries, one for bleach, but a multitude of them. Only occasionally is quality the core differentiator. Increasingly, it's a question of brand (i.e., covering marketing costs), social media support, and algorithms that derive users' demand and utility functions largely illegally. If, as you say correctly, monetary policy should focus on inflation, then it is urgent that we understand how, in a world of de-structured, ultra-global consumption, we can precisely evaluate price pressures, especially if a change in monetary policy can be justified by five decimal points higher or lower than the target.