US Federal Reserve chair Kevin Warsh seemingly wants to outsource monetary policy to financial markets. In his telling, the central bank’s job is to referee and not influence market expectations.
To ensure that outcome, he argues that not only is it essential that the Fed provide no forward guidance about the future path of interest rates, but also that the Fed not explain how it would likely respond as circumstances change; that is, not explain the central bank’s monetary policy reaction function.
I have no quarrel with ending forward guidance when the Fed is not at the zero lower bound for short-term rates. In most other cases, forward guidance is unnecessary and may at times be counterproductive by making it more difficult for policymakers to rapidly shift course.
But when Warsh goes far beyond that and refuses to provide information about what is important to him and the Fed in conducting monetary policy, that is where I get off the bus.
Warsh’s idea of outsourcing monetary policy to financial markets is terrible for several reasons.
First, if financial market participants do not understand the Fed’s reaction function, then they are going to do a poor job assessing how the economic data will influence monetary policy.
This will make monetary policy less efficient, prone to more room for error between what the market expects the Fed will do and what it will actually do, and less timely, with financial conditions slower to adjust in a way consistent with likely future changes in monetary policy.
In other words, the link between monetary policy and its impact on economic conditions will be looser and slower.
Second, financial markets price by what they expect the Fed will do, not what it should do. So, when the central bank is silent about how it is interpreting incoming information, policy expectations become more muddled and indeterminate—the Fed looking at markets, with markets looking at the Fed. This is a recipe for confusion, greater volatility and higher risk premia.
Third, this approach threatens to undercut the Fed’s credibility. This was evident in late July as investors responded to Warsh’s press conference by lowering short-term rate expectations (the 2-year Treasury note’s yield fell) and raising risk premia and inflation expectations (10-year and 30-year Treasury note yields rose).
Fourth, if Warsh is going to be silent about the Fed’s reaction function, market participants will just get their information from other policymakers. Continuing with his ‘no comment’ approach will undercut Warsh’s own influence as the Fed chair.
By not tightening US monetary policy, Warsh missed a chance to rebuild Fed credibility. This would have helped square the circle between his rhetoric—commitment to a 2% inflation goal—and action.
A rate hike would have made it clear that Warsh was in charge and not beholden to market expectations. If the Fed tightens policy in September, Warsh may be viewed as having been forced to act to restore his credibility and/or to avoid being viewed as having lost control over the rate-setting Federal Open Market Committee (FOMC).
What about the notion that the rise in US longer-term interest rates represents markets doing the Fed’s work for it? As Warsh noted, since the June FOMC meeting, medium- and longer-term rates have moved higher. This means that financial conditions are tighter and that should help exert restraint on the economy.
This is a problematic approach to monetary policy.
First, it is an inefficient mechanism for guiding the economy. Yields are higher presumably because of greater uncertainty about how the Fed will behave and its commitment to take the steps necessary to push inflation lower. Higher risk premia are a dead-weight loss to the economy relative to a well-calibrated and credible policy.
Second, yields may be rising due to a loss of confidence in the Fed. Higher long-term inflation expectations will make it harder for the Fed to push the inflation rate back down to its 2% objective.
So where do we go from here? Currently, markets have priced in about a two-thirds chance of a 25 basis-point increase in the target federal funds rate at the next FOMC meeting.
This is probably about right. After all, despite a strong case for tightening, the data between now and then could be consistent with a softer economy, weaker labour market and less underlying inflation pressure, which could cause the Fed to hold off and wait for more information.
But the Fed will likely need to tighten before too long. There is little evidence that monetary policy is currently restrictive, the Fed is missing only on the inflation side of its mandate and the rise in longer-dated yields underscores that the central bank’s credibility is at risk. The pressure on Warsh to back up his rhetoric with action might continue to increase. ©Bloomberg
The author is a Bloomberg Opinion columnist and former president of the Federal Reserve Bank of New York.