Kevin Warsh’s debut

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Good morning. The stock market was a bit surprised by Kevin Warsh’s hawkish tone at his first meeting as Federal Reserve chair yesterday (more on that below). Treasury yields jumped and the S&P 500 slipped 1.2 per cent, with the sell-off intensifying during Warsh’s presser. SpaceX also had its first wobble since debuting, falling 5 per cent. That wasn’t enough to unseat its astonishing position as the fifth most valuable listed company in the US. Email us and explain: [email protected].

The new Fed chair

Coming into Warsh’s first meeting as chair of the Fed, there were four questions that the market — or at least Unhedged — badly wanted answered. They were, in order of importance: 

1. Before he got the chair, Warsh argued that a future AI productivity boom justified pre-emptive rate cuts. Just an effort to kiss up to President Donald Trump — or does he actually believe that stuff?

2. How will Warsh respond to the ugly fact that inflation is a stubborn percentage point or so above target, even putting aside the effect of oil prices?

3. What will Warsh say about the timing and method of shrinking the Fed’s balance sheet?

4. How will Wash implement his aim of a more austere Fed communication policy?

We now have answers to all four, though some are much more satisfying than others. 

The AI question is really a question about whether Warsh is a hawk or a dove, or rather whether he is a hawk or dove under current economic conditions (he has been both at different points in the past). Asked directly whether he thought AI was adding more to demand or supply right now, Warsh hedged a bit, saying that supply was hard to measure. But he did allow that higher demand might be the bigger effect right now, which makes the possibility that he is a wild-eyed, ideological dove seem less likely. Phew. 

Warsh’s handling of the ugly fact of core inflation was encouraging. He said bluntly and repeatedly that inflation was still too high, that this excess was the product of bad monetary policy, and the Federal Open Market Committee would now set things right. He gestured towards the employment side of the Fed’s mandate only when prodded. This, and the fact that half the committee put a rate increase in their policy projections, was more than enough for the market to conclude that the Fed is moving in a hawkish direction. The policy-sensitive two-year Treasury yield leapt as must as 17 basis points after the meeting.

Warsh’s performance as a hawk was not perfectly convincing, however. Asked if he thought rates were currently restrictive, he replied that it varies. In the housing market, yes; in the stock market, clearly not. Part of the issue, he said, could be two different Fed tools — rates and balance sheet policy — which might be influencing different parts of the economy. But if Warsh is suggesting that the bonkers stock market is a product of a big Fed balance sheet, and so can be left out of the conversation about rates, he should explain why, when the balance sheet shrunk from $8.7tn to $6.8tn between 2023 and 2025, the stock market rose around 50 per cent.

Which brings us to plans for the balance sheet policy question. The committee’s statement affirmed the commitment to an “ample reserves” regime in its second sentence, while one of the five reform task forces Warsh is setting up will address the balance sheet. Key message: no rush, but change is probably coming.

The communication question was answered decisively. All forward guidance (coded talk about the Fed’s expected direction of travel) was taken out of the committee’s statement. In the press conference, Warsh flatly refused to answer questions about what the Fed’s “reaction function” (sensitivities to incoming economic data) might be under his leadership. Finally, he set a parsimonious example by not contributing a “dot” to the committee’s economic projections.

This is fine. It’s not clear how much good all that verbiage did. But Warsh’s explanation of the change was nonsense. He argued that financial markets need to react to information directly, not through the filter of anticipating what the Fed’s interpretation will be. This filter, Warsh said, left the Fed “blind” to what was really going on in the economy. But of course the market will still interpret new information in light of what it thinks the Fed will do, and the likely response of the Fed will remain as important as ever. The only difference is that markets might have less information about what the central bank is inclined to do.

The charitable interpretation of Warsh’s silly argument, pointed out to me by Brij Khurana of Wellington Management, is that he wants to kill the presumption that the Fed will depress volatility in the market by implicitly promising certain policy responses. That is to say, this is a tiny step towards removing the “Fed put”. If that is what Warsh really means, good. When markets are not volatile enough day-to-day, that encourages false confidence, which distorts the cost of capital and encourages recklessness.

It is worth noting, however, that the withdrawal of forward guidance can serve as cover for not answering hard questions. Warsh was asked twice: if inflation is too high, and inflation is solely a matter of monetary policy, why not raise rates now? That question is pointed squarely at the past and deserves an answer, given Warsh’s otherwise hawkish posture. He treated it, unconvincingly, as an attempt to trick him into talking about future plans, and said nothing.

One good read

Post-Farc.

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