A Retro Fed for the Future?

On his 99^th day as Fed Chair, Kevin Warsh delivered a much-anticipated keynote speech at the Kansas City Fed’s annual central banker shindig at Jackson Hole, Wyoming. He opened with a discussion about hikes (the outdoor kind, presumably inspired by the Tetons) and closed with a commitment to “a discipline, not to a decision.”^[i] Financial coverage focused on Warsh’s inflation comments—with some presuming a hike is coming in September—though we think that is a bridge too far. To us, the speech was mostly a nothingburger—which isn’t a bad thing! Fewer fireworks from the Fed would be a welcome change—one that likely helps, not hurts, Fed credibility. 

Warsh’s speech was over 3500 words, spanning topics like AI, productivity, inflation and his current economic assessment. He also addressed his most controversial move since becoming Fed head: curtailing forward guidance, aka, the central banker strategy of using words to preview and augment policy choices. Warsh dedicated nearly a quarter of his speech to explaining his rationale, arguing forward guidance may have helped during the global financial crisis, but “the practice overstayed its welcome.”^[ii] In his words:

Oversharing policy deliberations and overcommitting to future decisions can lead markets, businesses, and households astray. And I believe when policymakers make quasi-commitments on interest rates through the cycle, we inhibit our own freedom to make the right calls when it’s time to decide.^[iii]

That sounds logical to us. The Fed and other central banks have a spotty forecasting record. They often update their views if economic conditions and the data change, which is sensible enough in principle. But when you have unnecessarily boxed yourself into a corner with guidance, that looks to market participants like a surprising U-turn. It can exacerbate volatility as such. Ending forward guidance looks sensible as a result. Only time will tell whether the Fed follows through or not, and how Warsh can convince his colleagues on the Federal Open Market Committee (FOMC) to join in. But Warsh’s general direction of travel on this matter looks right.

Most headlines we saw focused on Warsh’s comment that the Fed “has to work to do” if inflation isn’t moving toward its objective. Some commentators believe that makes a September rate hike inevitable since the Personal Consumption Expenditures price index rose 3.7% y/y in July, well above the Fed’s 2% annual inflation target. Perhaps. But all that speculation is boring, old hat to us. Trying to predict central bankers’ actions is futile, as their squishy words aren’t a reliable roadmap for future action, forward guidance or no.

However, Warsh’s speech did contain a few notable nuggets, including “key principles” that guide his monetary policy thinking. In addition to reaffirming a commitment to the Fed’s dual mandate of price stability (defined as a firm 2% inflation target based on the personal consumption expenditures price index) and maximum employment, Warsh pushed for simplicity. He said short-term interest rates are the Fed’s primary monetary policy tool and that “unconventional policies to spur economic activity” (read: quantitative easing’s, or QE’s, long-term bond buying or other special measures) should be used “sparingly, if at all.”^[iv] Warsh also shared a belief in monetarism, i.e., the theory that changes in money supply are the primary driver of inflation and growth. Relatedly, he expressed doubt about the wage-price spiral (i.e., the theory wages drive inflation), saying, “In tracking underlying inflation, wage growth has not proven to be a reliable indicator of future inflation for a very long time.”^[v] And to reiterate his steadfastness to ending forward guidance, Warsh argued less Fed chatter is better since too much communication risks distorting the very market signals the central bank is trying to read:

If markets rely materially on the Fed's guidance and the Fed relies on market prices, we are all more likely to be blinded to new developments . . . more likely to be caught unprepared for a turn of events . . . and more likely to commit errors in policymaking.

Now, as with any Fed official, Warsh’s words, words, words are just that. He may change his tune for any number of reasons, from political pressure to a change in philosophy to simply forgetting after taking Martin’s Little Pill. But this keynote speech sets a baseline to assess the Warsh Fed’s decision-making. Should he stray from these stated principles—e.g., veering into sociological matters like climate change as some of his predecessors did—those departures may ding his credibility, which risks sowing uncertainty and confusion for market participants.

For now, we don’t think Warsh is doing anything revolutionary. Rather, his approach is in line with typical Fed behavior, especially pre-global financial crisis. As we have written before, boring, shorter Fed communications aren’t bad for stocks or the economy. Forward guidance hasn’t proven to benefit markets, and it has arguably added more confusion than clarity. For instance, in late 2012, former Fed head Ben Bernanke said rates would remain near zero “at least through mid-2015,” as long as the unemployment rate remained above 6.5%. Unemployment dipped to that level in April 2014 but the Fed didn’t hike—knocking Fed credibility. On the flipside, Bernanke’s alluding to winding down QE in early 2013 stoked volatility and caused a “tamper tantrum” in which global stocks dipped and Treasury yields jumped. These issues weren’t confined to the Bernanke Fed, either. Considering one of forward guidance’s purposes is to reduce Fed-induced volatility, it didn’t work. So if the Warsh Fed does indeed say less, markets have less noise to sort through, which allows them to focus on other drivers, including the economic environment and/or political developments (e.g., elections or new regulations).

Now, we don’t live in Shouldlandia, where everything in the world is as it should be in its ideal state. So it is unlikely we will ever fully retract forward guidance and end the world’s vast over-fixation on all things central banking. Warsh may refrain from sharing his views, but he is only one voting member of the FOMC. Other Fed governors and officials give oodles of interviews and speeches—and that noise can still end up impeding the Fed’s overall credibility. But if Warsh is successful in weaning Fed observers off of diagramming every Fed sentence, that may help market confidence more than all the extra communication did. Less is more, and Warsh’s Jackson Hole speech suggests that is what we will get for the foreseeable future.