Unlock the Editor’s Digest for free
Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
Steven Kamin was previously head of international finance at the Federal Reserve and is now senior fellow at the American Enterprise Institute.
Kevin Warsh’s first press conference as chair of the Fed’s Federal Open Market Committee went largely as expected, but featured at least one large unwelcome surprise.
As widely predicted, the FOMC kept interest rates on hold (though half the participants signalled a future increase) and made no changes to its balance-sheet policy. Also as trailed, Warsh announced a range of working groups to address issues such as communications, inflation strategy, and balance sheet policy.
Finally, Warsh kept to his earlier playbook in underscoring his opposition to forward guidance, both by withholding his dot in the infamous “dot-plot” and by refusing to answer questions about future Fed moves.
But what did surprise a lot of observers was that Warsh’s antipathy to forward guidance wasn’t limited solely to formal communications like the dot-plot — he also ruled out explaining what developments might lead the Fed to raise rates in the future. As he put it:
I think financial markets perform best when they react to incoming data. I think the financial markets work less efficiently when they ask a question: How will the Federal Reserve react to that incoming information?
The more that markets are paying attention to what’s happening in the real economy, deciding what’s good data and what’s less good data, the more financial markets can price what they believe is the most likely and what the tail risks are.
Financial market prices are probably the most important source of information to guide central bankers. But when all the financial markets are doing is reflecting back what we’ve said, then we’re taking the most important source of information, and we’re being blind to it. I’d like us to create a system where those blinders come off, where markets are following data that they efficiently think is reliable, and they’ll be watching data, we’ll be watching data, and they’ll come with better information through market prices to us.
This kind of deliberate ambiguity — practised most notably by the late Alan Greenspan — does have its supporters (like Alphaville’s own Robin Wigglesworth). But Warsh is in practice turning his back on more than two decades of thinking about how central banks can use monetary policy to stabilise prices and lay the conditions for sustained economic growth.
That thinking revolves around the market’s understanding of the central bank’s “reaction function,” which is a fancy term for how the central bank adjusts monetary policy in response to inflation, unemployment and other economic indicators.
In principle, of course, everyone knows that the central bank should raise interest rates when inflation rises and lower them when unemployment goes up. But how much should interest rates be adjusted, and for how long, and what should be decided when the inflation and employment objectives are in conflict? These are the factors that are captured by the reaction function.
In recent decades, central bankers have come to understand that by helping financial markets understand their reaction function, they can actually improve the effectiveness of monetary policy.
For example, if markets understand that declines in unemployment below normal levels will eventually lead to higher inflation and higher Fed funds rates, they will bid up longer-term interest rates — this will help to cool the economy, even in advance of any action by the Fed.
Similarly, in response to a shock such as the Covid-19 pandemic in 2020, the markets brought down 10-year yields weeks before the Fed had a chance to act. Such responses by the market help do the Fed’s job for it and help stabilise the economy more effectively than if the Fed has to go it alone. As then-Governor Ben Bernanke put it in a speech more than 20 year ago:
. . . the more guidance the central bank can provide the public about how policy is likely to evolve (or about the principles on which policy decisions will be based), the greater the chance that market participants will make appropriate inferences — and thus the greater the probability that long-term interest rates will move in a manner consistent with the outlook and objectives of the Monetary Policy Committee.
So, in jettisoning not only forward guidance but even transparency about how the Fed’s policymakers view current economic conditions and might react to them, Warsh is throwing the proverbial baby out with the bathwater.
His strategy turns the clock back several decades to a more opaque Fed, when Greenspan could quip: “If I say something which you understand fully in this regard, I probably made a mistake.“ But the downside of opacity isn’t only that the market stops doing the Fed’s work for it.
Greater uncertainty about what the Fed intends to do — and how the Fed will respond to future economic developments — will accordingly raise uncertainty about the future course of the fed funds rate. And insofar as expectations of the future fed funds rate underpin current levels of longer-term interest rates, this will lead to higher borrowing costs for everyone, putting a damper on risk-taking, innovation, and investment.
As Bob Michele, JPMorgan Asset Management’s chief investment officer, told the FT:
I don’t like it because I don’t see the benefit of less transparency, which is where this seems to be headed . . . Of course less transparency means more guesswork, more uncertainty, more volatility, more risk premium, more event risk.
Full opacity probably isn’t a sustainable solution, and over time Warsh will find it in his — and the economy’s — interest to be more forthcoming about how the Fed assesses economic conditions and how it is thinking about the future.
But discovering that could require a painful learning process first.
