Digging Into Last Week’s Fed ‘Credibility’ Concerns

It seems new Fed head Kevin Warsh stepped in it last week, with headlines globally bemoaning his lack of monetary policy “forward guidance” and decision to answer reporters’ questions with word salad. Never mind that this simply reverts to the late Alan Greenspan’s playbook—headlines’ judgment was harsh, claiming the ensuing market volatility meant he messed up bigtime. We take a different view. We did spot an error, but it isn’t the one getting all the ink.

We wrote in June about Warsh’s decision to eschew forward guidance and not contribute to the Fed’s dot plot of forecasts, and our view hasn’t changed. In the two decades where past Fed heads practiced transparency and signaled their intentions, the goal was enhancing credibility. We reckon it did the opposite, though, as the Fed ended up defying its own forward guidance numerous times. Ben Bernanke said rates would stay near zero until unemployment hit 6.5%, a threshold that came and went without rate hikes. Janet Yellen said rate hikes would come about six months after quantitative easing (QE) ended. But the window ended up being more than a year. Jerome Powell downplayed rate hikes early in 2022, dismissing hotter inflation, then hiked far more aggressively than anyone expected.

So we can see why Warsh refuses to play this game. If you say one thing and do another, no matter how sound your reasoning for the shift, it tells markets you are shifty. It makes British politicians call you an “unreliable boyfriend,” as one member of Parliament famously called former Bank of England head Mark Carney. When bond yields ticked up after Warsh’s presser Wednesday, headlines said this was the market declaring Fed credibility cooked. That is an awfully grandiose conclusion to reach on a couple days’ volatility that wasn’t even all that sharp by historical standards (a rise of 0.14 percentage point over three days).^[i] But when cooler heads prevail, we think they will see he was drawing a line under 20 years of embarrassing Fed U-turns, which should restore credibility in time.

Yet as mentioned earlier, we don’t give our new Fed head’s comments perfect marks. Throughout the press conference, he referred to higher long-term interest rates as the market “tightening,” even implying at one point that long yields were doing the Fed’s job for him. This is a very modern central banker way of thinking: If long yields are up, it means the price of money (loans) for consumers and businesses is up, ergo, conditions are tight. We disagree. It focuses on loan demand, forgetting the supply side.

Consider a bank’s perspective. They get funding at short-term rates and lend at long-term rates. The gap between these—long rates minus short rates—is effectively their profit margin on new loans. The wider the spread, the bigger the potential profit, which is an incentive to lend more. You can gauge all of this via the yield curve, which plots US Treasury yields, short to long. It is only a rough proxy, since banks don’t lend at Treasury yields. But overnight and three-month yields are good measures of banks’ funding costs, while 10-year Treasury yields are reference rates for new loans. So when the yield curve is “steep,” with long rates far above short, then financial conditions are pretty loose. When it is flat or inverted (short rates above long), it means new loans are less profitable, which discourages lending—tighter conditions.

So what is the problem? Warsh called higher long rates “tight.” But long rates’ rise over the last month steepened the yield curve. On June 29, one month before the Fed’s July meeting, the spread between 3-month and 10-year US Treasury yields was 0.51 percentage point.^[ii] By the end of last Wednesday, the Fed’s meeting day, it was up to 0.84 percentage point.^[iii] Now it is up to 0.92 percentage point at Friday’s close.^[iv] Policy isn’t tighter. It is looser.

This isn’t a problem today. A modestly steep yield curve here and globally promotes the lending that feeds economic growth. Conditions don’t appear to be overheating, given broad money supply is growing at mid-1990s rates—not an era of hot inflation. But what if we get to a point in a year, two or three when long rates are lower and the yield curve is flatter? What if Warsh and the rest of the brain trust see this as “loose” policy, considering only lower long rates and ignoring the yield curve? What if they hike aggressively, inverting the yield curve and inducing a recession?

Again, we aren’t there now. This is a possibility, not a probability and not something you can predict or position for now. But we see it as a philosophical error that gives us a window into what a policy error might look like under this Fed. For now, we will be watching, listening and weighing decisions as they arrive.