A Fed Chair Nominee Emerges. What Might Warsh Forget?

Finally, on this, the last business day of January, we know which Kevin President Donald Trump will nominate for Fed head. Mr. Hassett will keep his role as White House economic adviser, while Mr. Warsh will take the Chair at the Marriner S. Eccles building in May, presuming the Senate confirms him. The general take is that this is a sound choice, with Warsh’s newspaper editorials and voting record from his days as a Fed governing board member the evidence. Those are fine enough things to look at, but Fed heads are always unpredictable, and none negate monetary policy risks. Markets will probably keep looking past names and personalities and weighing policies as they evolve.

On the surface, Warsh’s appointment seems to undercut one big fear: that Trump would pick a left-field candidate who will cut rates aggressively. Warsh is not left-field. He served on the Fed’s board from 2006 – 2011 and never cast a dissenting vote.^[i] Reputationally he is a “hawk,” meaning he focuses more on the inflation-busting aspects of the Fed’s goal than boosting growth and employment. Since departing, he has written frequent op-eds arguing the Fed has strayed too far from its mandate through quantitative easing (which he views as wading into fiscal policy), redefining its inflation target and considering sociological factors when weighing monetary policy. Thus, headlines portray him as a potential reformer who is unlikely to let the White House sway policy.

If you would like to interpret his articles and monetary record thusly, be our guest. But also, be forewarned: Fed heads often act radically different from what everyone expects, seeming to forget everything they ever knew. As Fisher Investments founder and Executive Chairman Ken Fisher explained in his classic book The Only Three Questions That Count:

Traditionally, former Fed chairs were derided for their many mistakes at mismanaging the economy. William McChesney Martin, Jr., Arthur Burns, G. William Miller, even the legendary “Maestro” Alan Greenspan—they were all criticized widely and wildly after their time. Before he became chairman, Burns criticized Martin nearly endlessly. Martin ran the Fed from 1951 to 1970, giving Burns plenty of time to attack him. Burns claimed Martin knew better than to make the mistakes he did.

Martin later claimed when you became head of the Fed, you took a little pill making you forget everything you ever knew, and the effect lasted just as long as you were head of the Fed. After becoming head of the Fed and coming under attack himself, Burns claimed he took “Martin’s little pill.”^[ii]

In recent history, Martin’s little pill seemingly made renowned Great Depression scholar Ben Bernanke forget everything he knew about that era, leading him to shun simple tools like the discount rate in favor of an alphabet soup of complicated liquidity programs that didn’t really work during the financial crisis. Then it seemingly made Janet Yellen forget she isn’t Bernanke, as she mostly extended all his policies. And we reckon it made Powell forget that if you massively increase money supply while preventing the production of goods and services, you will get hot inflation. Who knows what Warsh will forget, but we suspect there will be some headscratcher no one expects or can forecast now.

Because of this, and because everyone is human, we don’t think Warsh’s appointment ends one of the risks we have identified this year: That a new Fed head would push massive rate cuts that risk overheating the economy, setting up this cycle’s end. We aren’t saying the risk got higher. Just that you can’t cross it off the list because Warsh has a nice resume and his historical positions argue against it. All Fed heads are human. Prone to error. Prone to change their minds. Prone to play politics. That said, given the Fed’s groupthink, we think it remains a distant risk.

Beyond that, there is something else we think deserves scrutiny: the Fed’s role as lender of last resort in a crisis. This was the chief error during Bernanke’s tenure involving 2008, and Warsh was there, a voting member of the Federal Open Market Committee (FOMC). So we revisited Fed transcripts to see what he said during key meetings.

The most consequential meeting during Warsh’s tenure occurred September 16, 2008, the day after Lehman Brothers failed. A quick keyword search of this transcript confirmed our loose memory that Warsh is indeed responsible for one of our favorite moments in Fed history: the great adverb debate of 2008, when FOMC members argued over whether and how to insert the word “closely” into a general statement about monitoring economic and financial conditions.^[iii] Hopefully Martin’s little pill doesn’t rob us of tomfoolery like explaining he wanted that particular adverb because “we want the focus to be that we are really watching market developments closely.”^[iv] Closely means closely? You don’t say …

Alas, we think the good stops there. As a refresher, Lehman Brothers didn’t fail randomly. It was in the same predicament as Bear Stearns six months earlier: solvent on paper, with assets exceeding liabilities, but illiquid and unable to get overnight funding. When Bear Stearns faced this, the Fed brokered and backstopped its sale to JPMorgan Chase. When Lehman was teetering, Bank of America (BofA) and Barclays lined up as potential suitors. After the Treasury rejected BofA’s proposal, Barclays looked like a sure thing … until the Fed and Treasury refused to backstop it as they had done JPMorgan Chase. This effectively forced Lehman to fail, prompting the market mayhem that followed. But in the heat of the moment, several Fed and Treasury officials congratulated themselves for a job well done, bragging about preventing “moral hazard.”

So how did then-Governor Warsh view this? “I think the work that was done over the past few days on Lehman Brothers should make us feel good in one respect. Market functioning seems to be working okay—by which I mean that the plumbing around their role in the tri-party repo business, due in part to the Fed’s actions, seems to be working. It’s ugly. The backroom offices of these places are going crazy. There’s a lot of manual work being done. So they wouldn’t give it high marks. But it looks as though positions are being sorted out in a tough workmanlike way, and so that’s encouraging.”^[v]

He went on to contrast Lehman’s allegedly small financial footprint with AIG’s supposedly massive one: “My own view is that the AIG question would be more financial devastation if these institutions turn out to be meaningfully insolvent but actually, in some ways, less market dislocation among intermediaries. That is, Lehman Brothers, Merrill Lynch, and Bear Stearns are touching and are in the middle of many more flows of data, and there are real losses being felt. But if an AAA company like AIG were really fundamentally insolvent, the direct losses to a range of institutions, particularly those that are not just wholesale institutions but are retail institutions, could be very significant.”^[vi] Later that day, the US Treasury began the process of nationalizing AIG.

Put these together, and it seems Warsh was pretty on board with the haphazard government response that wreaked havoc on markets in 2008. When you force some institutions to fail, marry off some others, bail a few out and nationalize others, it tells investors the government is indiscriminately picking winners and losers. When the Fed expressed concerns about moral hazard, it meant officials worried the market wouldn’t be able to price risk. But the market also can’t do that when the government is using a dartboard to pick which financial institutions live and which die. We think that haphazard approach was directly responsible for the S&P 500’s -24.2% drop in September and October 2008.^[vii] Perhaps Warsh’s view of this period has changed with time and reflection. One would hope the senators who will grill him before confirmation have the sense to ask him. But at the time, we think one can fairly interpret these remarks as cosigning the government’s choices.

We point this out to show you taking Martin’s little pill can be a benefit as well as a drawback. Maybe he will forget to pick winners and losers if he is tasked with steering the ship through a crisis! That would be swell. But our broader point is that you must take these things as they come and weigh decisions as they are made, rather than try to predict decisions and their effects.

Now. That was all really heavy for a Friday, so let us leave you with this Abbott & Costello-style palate cleanser from that same September 16, 2008 transcript.

CHAIRMAN BERNANKE. Well, it is not an analytical thing we are doing. We are just watching closely.

MR. WARSH. Keenly? Carefully?

MR. LACKER. Mr. Chairman?

CHAIRMAN BERNANKE. Yes. President Lacker.

MR. LACKER. Including “closely,” what does that imply about the opposite? I mean, are we going to be able to take that out?

MR. WARSH. Well, we have done things like “in a timely manner” and other kinds of phraseology.

MR. LACKER. Yes, but this is an adjective.

CHAIRMAN BERNANKE. No, it’s an adverb.

MR. LACKER. There goes my credibility. [Laughter] If we take it out, can we use the phrase without it?

CHAIRMAN BERNANKE. What we have done in the past is basically just use a new phrase.

MR. LACKER. So that means we have to throw this phrase out.

MR. WARSH. Mr. Chairman, I would support “carefully.”

…

CHAIRMAN BERNANKE. Any other comments? All right. Let me just ask for a straw vote: “closely,” no “closely,” or “carefully.” Do we want “carefully”? All right. Is “carefully” more acceptable to those who are concerned?

MR. KOHN. It’s less of a code word. The intention was to loosen it up a bit but not revert to those code words that nearly promise intermeeting action.

MR. PLOSSER. We make note of this in the lexicon of FOMC terminology.

CHAIRMAN BERNANKE. The semiotics class will begin as soon as the—[Laughter] All right. “Carefully”—is that okay? I’m seeing nodding. All right? Governor Warsh?

MR. WARSH. Yes, sir.

MR. KOHN. I’m closing the dictionary.