The Missing Reaction Function

The FOMC meets this week amid unusually high uncertainty.

According to the FT, markets are pricing a 38% chance of a rate hike up from 13% a week earlier. What’s more, the uncertainty around the outcome has translated into 50% more trading on fed funds futures versus the same meeting last year.

Whereas under Powell, the outcome may have been leaked via Nick Timiraos in the Wall Street Journal, Kevin Warsh has brought a communications revolution to the Fed. He has downplayed forward guidance and dot plots and instead wants markets to make their own assessment on where rates are heading.

The approach has merit. Forward guidance was a policy designed for a different era, when interest rates were near zero and shaping expectations became a policy tool in its own right.

But there is an important distinction between giving guidance on the path of rates and explaining the framework used to set them.

Warsh has withdrawn the former. Markets are still waiting for the latter. Until they get it, greater volatility, a higher term premium and questions over the Fed’s credibility are likely to persist.

The Warsh revolution

Before his appointment, investors were split as to whether Warsh would be a dove or a hawk as Fed Chair. That question has yet to be truly answered. But what is clear to date is that Warsh intends to take a radically different approach when it comes to Fed communications.

We already saw this at his first FOMC meeting In June. Unlike his FOMC colleagues, he declined to submit a forecast to the dot plot. The statement after the meeting was much shorter than before. And in the press conference following the meeting he offered little insight on his thinking about the economy or the likely path for monetary policy.

Warsh believes forward guidance can be a bad thing. It can box the Fed in and remove its policy flexibility. It also removes an important source of information for the Fed – the markets themselves.

He believes if markets can tap into the wisdom of the crowd, and formulate their own opinion on the likely path of interest rates, that can be valuable information for policymakers.

A policy for a particular time

There was a time when the Fed was much less transparent on its thinking. Greenspan was famously opaque with his guidance, and it was only in 1994 that the Fed started to issue a statement after the FOMC meeting.

It was Ben Bernanke who set out the case for greater transparency in a couple of speeches in 20041. Bernanke argued that the Fed only controls short term interest rates, and it was long-term interest rates that really mattered for the economy. In that era, before QE had become a policy option, better communications by the Fed could help the market calibrate future policy which, in turn, could help the Fed influence long-term interest rates.

When the Fed hiked in 2003-2006, perhaps conscious of not repeating the 1994 bond market meltdown, they emphasised rates would go up “at a measured pace”. And after the GFC when rates were already zero, they signalled rates would stay low “for an extended period” to try and anchor long-term rates as well as short-term rates.

But over time, guidance has evolved from a goal of influencing long-term rates to drip feeding every decision to the market, seemingly to reduce market volatility. It has had costs as well, arguably tying the Fed’s hands somewhat when they needed to tighten in 2021.

But we’re now in a different era. The Fed has other tools and there is a greater uncertainty. Tariffs, AI and supply shocks have all created policy dilemmas for central bankers meaning making commitments about where rates may be heading over a period of time has become fraught.

Two kinds of guidance

But there is a difference between forward guidance on interest rates and guidance on how the Fed is thinking about the economy. Less precommitment on rates may not be a bad thing but no guidance on the framework leaves a huge vacuum for markets.

The issue is particularly acute given the current macro backdrop. Tariffs and supply shocks have already made policy making more challenging, but AI is the real conundrum.

There is a demand element (investment in chips and data centres) and a supply side (greater output from higher productivity) element to AI. Currently the demand impact is more obvious and is pushing up inflation. Former Fed Vice Chair Rich Clarida, now at Pimco, estimates AI-related spending may have boosted core inflation by 0.5%.

For policymakers it creates a dilemma captured by the question:

What is the appropriate policy response to something that appears to be pushing up inflation in the near term but is likely to be disinflationary at some point down the line.

The textbook answer is that a productivity shock should translate into higher trend growth and higher interest rates, but Warsh has appeared sympathetic to the disinflationary arguments in the past. And at a recent central bankers’ event in Sintra he remained ambiguous about his answer.

The credibility question

Less transparency and guidance may have merit but for Warsh it has also offered some convenient breathing space.

To date he hasn’t been forced to lay out his take on the economy, the balance of risks or the appropriate policy. The question of whether he is truly a dove, a hawk, or a pragmatist remains unanswered.

Before his appointment there was real concern in markets about Fed independence. The possibility that Kevin Hassett, Director of the National Economic Council, may be appointed was seen as potentially damaging to Fed independence.

Warsh’s background as a former Fed governor has given him immediate credibility, and in his first press conference, he talked tough about price stability, assuaging those who were concerned he may insist on easier policy to satisfy Trump’s demands for lower rates.

His five taskforces, focused on everything from communication to inflation to the conduct of monetary policy, are also reasonable, but also provide a justification for inaction.

Why commit to a particular policy approach without first hearing what the taskforces come up with?

The real test

To date markets have given him the benefit of the doubt. The curve flattened after the FOMC meeting, breakeven inflation rates have remained steady and gold fell as the debasement trade seemingly went out of vogue.

By strongly committing to price stability, he has won some initial credibility without action. But that will only last so long.

Many questions remain unanswered. Warsh has talked about underlying inflation without offering a definition and he has mooted balance sheet reduction without providing a framework. He has offered no real opinion on the economy. Markets have no sense of his reaction function.

And tough choices lie ahead. His FOMC colleagues are biased to higher not lower rates as evidenced in the last dot plot, as the labour market has stabilised while inflation remains above target. But with the mid-terms now coming into view a rate hike in the next few months would be politically exceptionally unpalatable.

Perhaps his calculation is that by December, when the taskforces report, oil prices will have fallen, the impact of tariffs will have rolled out of the inflation data, and there will be more evidence of AI-related productivity gains.

But that’s not without risk. If inflation remains above target and the economy is strong, the calls for higher rates will grow louder and investors will ultimately need a plausible reason as to why the Fed is not moving on rates.

Warsh may have bought some time, and no change remains the most likely outcome this week.

Ultimately, credibility is earned by action, a coherent policy framework and achieving policy targets. That, more than any communications strategy, will determine the credibility of the Warsh Fed.