What markets, Mervyn and Maradona tell us about Fedspeak

A little over six weeks into Kevin Warsh’s term as Federal Reserve chair, everyone is still trying to work out how the central bank will behave. Uncertainty reigns over the way it will communicate in future, but more importantly, on how to infer its likely monetary policy stance from news, data and the words spoken by Warsh and other participants in the Federal Open Market Committee.

The 10 tensions I noted a couple of weeks ago remain. But we have learnt some more from Warsh’s appearance with other leading central bankers at the European Central Bank’s annual Sintra conference. Bloomberg also reported last week that Warsh has turned to former Bank of England governor Mervyn King to steer his communications task force. King’s tenure as BoE governor is a bit of a specialist subject of mine and this reveals a little more about the path a Warsh Fed will probably follow.

Forced bonhomie among the brotherhood

No one should ever expect a frank discussion about monetary policy trade-offs in a public discussion between central bank governors. However much they might privately disagree, they protect each other and want to avoid any signs of splits. That said, the bonhomie on display this year in Sintra was rather forced.

ECB president Christine Lagarde had sought to minimise any differences earlier in the week by redefining the term “forward guidance” to mean a specific commitment to a future path of interest rates instead of just how the central bank would think about setting interest rates.

She coined a new term, “framework guidance”, which she said was different, but many would say falls within the previous definition of forward guidance. This framework guidance, she said, sets out how the ECB would think about setting interest rates in different contingencies — Ie. how the framework for setting interest rates works.

Warsh responded by saying that he had liked Lagarde 20 years ago when she was French finance minister and “after that answer, I love her”. Things were going swimmingly.

But Warsh then blew it, by refusing to give any framework guidance of his own. He simply said “people understand quite well” the Fed’s reaction function. It was a bold claim.

A confusion of correlation and causation

Warsh is smart. He is certainly smart enough to understand the distinction between correlation and causation. I was therefore slightly baffled by the evidence Warsh cited for his view that people understand the Fed’s reaction function pretty well. I will quote it in full.

“It is said in recent weeks we need to know more about your reaction function. [But] if I look at trigger pullers [for] people that are making decisions in the bond market, in a range of markets: volatility is not up, it’s down; yields aren’t up, they’re down; [and] inflation expectations are down. So I hear this that as if people don’t understand. I think they actually understand quite well.”

The claims about market pricing are broadly consistent with the facts as the charts below show. Bond volatility and yields have been pretty stable and perhaps a little lower, but inflation expectations have fallen since Warsh became Fed chair.

Warsh associated those moves explicitly with people understanding the Fed’s reaction function. That claim is far too strong and is not demonstrated by those price changes.

First, no one should ever reason from a price change.

Second, oil prices are also down over the same period and expectations of interest rates have risen, correlating with falling inflation expectations, as the second chart below shows.

I am not going to reason from these price changes, but I am going to say with some confidence that the memorandum of understanding between the US and Iran caused the fall in oil prices, which directly lowered inflation expectations and quelled bond volatility and yields.

Warsh’s reasoning was a straightforward confusion of correlation and causation.

Not Mr Transparency

This brings us to former BoE governor, Mervyn (now Lord) King. He certainly has always understood the difference between correlation and causation. He would regularly lecture journalists about the importance of not confusing the two. He would articulate these unprepared missives in perfectly formed paragraphs requiring no editing. Such oratory was remarkable and often fostered clear and effective communication.

His appointment to lead the communication task force has not yet been announced. But if King is chosen, my experience suggests that those covering the Fed should be a little concerned about where the Fed might be heading. Here are three transparency anecdotes from the 2003 to 2013 period when King was BoE governor.

The BoE always held press conferences alongside the quarterly inflation report. Transcriptions were not provided by the BoE until May 2007. Because correlation does not equal causation, I cannot tell you that the FT’s decision to publish its own transcripts forced the BoE’s hand, but I can tell you that the BoE press office was not happy when we informed it we were going to publish in the interests of transparency.

At the time, the BoE also refused to supply journalists with the numerical parameters of its forecasts, preventing observers from having a clear view of the BoE’s central forecast, the risks surrounding that and how the outlook had changed from three months earlier. King used to delight in this.

In August 2007, for example, he said: “In this report we are trying to help you get away from this terrible habit of people getting their rulers out to see precisely where this forecast is going to be in two years’ time . . . And if you’re really interested in the question of what will happen to interest rates, which I take it is what’s driving your interest in this, then forget getting out a ruler, throw your rulers away, be liberated . . . and start to think”.

It felt patronising at the time and reinforced the FT’s view that we needed to get our rulers out to let readers know how the BoE’s forecast had changed. I used to keep a completely pointless but detailed spreadsheet of my measurements.

In a 2010 speech, King acknowledged the problem, admitting that the BoE’s opaque communication through charts without parameters “[did] not readily permit comparisons between successive forecasts”. Until he left the bank, however, the changes were minimal.

The third anecdote on transparency is simply the procedure the BoE adopted under King for announcing a decision. Take the November 2006 meeting as a random example. On November 9, the BoE announced interest rates were raised to 5 per cent with a short statement similar to the one that Warsh has introduced at the Fed, but without the results of the Monetary Policy Committee’s vote. At a press conference on November 15, the inflation report was published showing the MPC’s collective view. No one was allowed to ask whether the committee was unanimous. Only on November 22 did the minutes reveal the vote was seven to two in favour.

It was not an important meeting, but the lack of transparency about what had happened was absurd. King loved it.

The irony of all ironies

Some of the lack of transparency in the King BoE was swept away by the former governor himself in 2007 and 2010. I would like to claim the FT’s constant pressure and probing about the lack of transparency were influential.

Much of the rest was removed after an expert task force led by Warsh. The current Fed chair was called in by Mark Carney in 2014, King’s successor, to do away with King’s secrecy.

My favourite line in Warsh’s report is his view that effective central bank communication requires households, businesses and financial markets “to understand the likely reaction function of policymakers to incoming information”.

Unlike most of the examples in the Alanis Morissette song, this is indeed ironic.

Maradona no longer to the rescue

I could stop here, but the moment people talk about King, they tend to nod sagely and say his communication approach is something to do with his 2005 “Maradona theory of interest rates”.

Just as English football players in the 1986 quarter-final reacted to what they expected Maradona to do when he scored his second goal, King said, “market interest rates react to what the central bank is expected to do”.

He has since complained that central banks were too passive post-Covid and could not rely on anchored inflation expectations but instead should have raised rates earlier so that everyone believed the central bank was serious about inflation control.

He now calls this the King Canute theory of interest rates. It is not a direct contradiction of the Maradona theory, but shows the 1986 metaphor can be used only in extremely limited and precise situations.

Now is not one of them. So this is the last time I will mention Maradona.

What this means for Warsh

It is early days, but I would expect frustration to emerge with Warsh if he refuses to talk about the future or the Fed’s reaction function, ducks reasonable transparency and does not respond to people asking legitimate questions.

As a warning from history, King did not like it when journalistic frustrations boiled over in November 2008 and he was asked why the BoE had got the economy “so spectacularly wrong” and whether he personally had been caught with his “pants down”.

(For communication clarity, pants in British English means underwear, not trousers.)

What I’ve been reading and watching

• President Donald Trump says he will still pursue the removal of Fed governor Lisa Cook after the Supreme Court ruling

• US voters do not think its war with Iran was worth the cost

• When asked whether substantially less forward guidance from the Fed would improve the US economy, 53 per cent of economists disagreed when surveyed by the Kent A. Clark Center for Global Markets. Only 12 per cent agreed

One last chart

In May, financial markets were certain the BoE would raise interest rates by July, giving almost a 40 per cent probability to two interest rate increases. Now there is virtual unanimity that the BoE will hold rates.