The Hawk Has Landed
Regime change comes to the Fed.
This was not a good week for President Trump. Instead of regime change in Iran he got it at the Fed, and not the kind he hoped for. Instead of cutting interest rates, new Fed Chair Kevin Warsh cut the policy statement in half and jettisoned the easing bias. Everyone expected a pliant dove. Instead, the hawk has landed.
The hawkish shift came as a shock to the media and the markets. Warsh reiterated his view that inflation is a choice, a monetary policy choice — and the Warsh Fed has chosen to bring inflation back to its 2% target. We will see how it plays out, since the FOMC is still divided: half of its members see rates moving higher, half see rates lower or unchanged. But Warsh has set the stage for a clean break from the dovish bias of the past two decades.
Give me data
The true regime change, however, comes in a commitment to review and overhaul the Fed’s approach to data, communication policy, innovation, inflation analysis, and its bloated balance sheet. Five task forces including outside experts with a variety of perspectives should deliver their insights and recommendations by the end of the year. This comes as a breath of fresh air, and goes far beyond the periodic reviews of the monetary policy framework.
When Warsh mentioned the task force on data, I poured myself a celebratory glass of wine (Sangiovese, in case you’re wondering.). I have lamented in previous blogs that economic policy relies on outdated and unreliable data, cobbled together from surveys with plummeting response rates. Warsh characterized them as “echoes of history” — a poetic and cutting indictment. Jobs data are subject to massive margins of error and outsized revisions; one third of inflation data are model “guesstimates.” In the age of big data, this is absurd. Surely we can come up with more timely and reliable gauges. It would be revolutionary because it is so basic and overdue.
The race between demand and supply
Warsh is bullish on innovation:
…artificial intelligence, and the latest generation of general purpose technologies is perhaps as important a change in the economy and business and households as we’ve had in my adult lifetime. It is filled with both a huge opportunity and with risks. I take both very seriously.
He is confident the US will emerge as a winner in the AI race and benefit from it. In past statements, Warsh suggested that faster productivity growth could make room for lower interest rates. Eyebrows arched in suspicion: will he use advances in AI as cover to cut rates? In this week’s press conference, he gave a pragmatic response: the economic impact of innovation boils down to a race between supply and demand. Currently, we’re mostly seeing the boost to demand coming from massive investment in energy, data centers, and chips. The question is to what extent and how quickly the resulting innovations will boost the supply side of the economy. How will we find out? Warsh quipped, “we have a task force for that.”
As you know, I’m cautious on the speed at which digital innovation can yield efficiency gains at scale. Execution is the hard part, especially in the world of atoms. The hype surrounding generative AI underestimates the challenge. But once innovation does boost supply, it will indeed increase the scope for stronger non-inflationary growth. And with so many people ranting about a job apocalypse, it’s refreshing to hear that strong productivity-led growth is something we should embrace, not fear.
A little less conversation
The Fed needs to stop being “the only game in town.” Warsh recognizes this. He’s not a fan of forward guidance. He wants the Fed to talk less, and financial investors to focus on the data, rather than on how the Fed will interpret the data. He’s absolutely right — especially if we can get better data.
Policy makers shouldn’t act like they’re always in emergency mode — which is what justified Fed forward guidance as well as persistently reckless fiscal policy. And since the macro environment is changing in more complex ways at a faster pace than ever before, as accelerating innovation overlaps with escalating geopolitical turmoil, we should all be trying to figure out how these changes will play out.
But financial investors ultimately care about asset prices, and the Fed has developed an unhealthy habit of stepping in whenever asset prices swoon. Warsh hinted at this when he said the current monetary stance might appear restrictive when looking at the housing market, but not when looking at financial markets. As long as the Fed plays this game, financial investors will care more about monetary policy support than about what’s going on in the real economy. And then financial markets can’t fulfill their crucial role of price discovery.
We are no longer in an existential crisis. We’re operating in a complex, messy, interconnected ecosystem. The last thing we need is a single point of failure.
Last time you accused me of being hard to please. With this new post you almost did it. But I can’t agree when you say that should financial markets be given better data and acted on it they would be able to fulfill their role of price discovery.
I mean: I wish it were that simple.
The problem is that our overblown financial markets, on which the equivalent of the GDP of several world countries is bought and sold every day, are in no mood to discover any price that is not the one they have in mind; and once they ‘discover it’, the following day they decide it’s not the right one and the embark on a new crusade to reach the day’s whim.
The reforms that were announced this week are laudable and way overdue and at least we will have a less egotistic FOMC and better data. But I find the idea that those will convince the markets to abstain from their - very remunerating - game of hopscotch just because a piece of data says so, quite naive.
The only reform that would achieve the realignment you hint at is the one that will never happen: restrict financial markets - volumes, trading times and rules and the whole shenanigan.
What is wrong/revolutionary with the idea that stock prices should reflect the long-term value of a company? What is wrong/revolutionary with the idea that we need to avoid that in a penthouse meeting room the destiny of a company, a country can be decided and enacted with a click?
But for all this common-sense, this reform will never happen and I know I should refrain from expressing opinions such as those unless I liked to be billed as a communist and anti-capitalism revisionist.
But let’s remember that capitalism pre-existed financial capitalism. So if supporting capitalism means accepting that financial markets are monetary-policy makers (you mention that markets move by guessing how the Fed will interpret a piece of - noisy - data… I think that, save for short term reactions neither data nor the Fed really matters to markets) then call me communist.
And, btw, this is unfortunately not something you can correct with the promise of draining excess liquidity, in my opinion. Because as you set up doing so markets will massively sell-off; with no one on the bid side, anyone who came up the idea of this reform will soon be (politically) decapitated, together with their bosses. The genie is out of the bottle - it has been for the last decades of monetary policy folly… now it’s too fat to get back inside.
If the deflator or headline CPI are running at 4%, whereas trimmed mean (core PCE) is running at 1.9%, has price stability been achieved?