Kevin Warsh Is Not Inspiring Confidence

When Donald Trump announced his intention to nominate Kevin Warsh to be his next Federal Reserve chair, I was underwhelmed with the pick, reasoning, “Warsh was probably the best nominee that someone like an uninhibited Trump could have picked, and that is truly damning with faint praise. While I don’t think Warsh will do any real short-term damage, I do worry about the long-term ‘debasement trade’ on the dollar if Warsh succeeds in compromising Fed independence.”

Six months later — two months after Warsh was confirmed and took the job — my assessment may have been too optimistic. Because there is increasing evidence of short-term damage.

This is partly due to perceptions that Warsh is sacrificing Fed independence to please Trump, who always wants low interest rates when he is president. After sounding like a super-inflation hawk when Biden was in the White House, Warsh has been less hawkish since Trump became president. This remains true since becoming Fed chair. Despite inflation being at 3.7% — well above the 2% goal — Warsh has voted to keep rates constant. Some market experts anticipate Warsh might actually cut rates just to stay in Trump’s good graces.

Warsh’s apparent about-face on inflation is a problem, but it’s not the problem.1 That would Warsh’s radical redefinition of what a Fed chair should do:

So far Warsh’s biggest move as Fed chair has been to announce five outside task forces to examine inflation frameworks, the effect of AI on employment, data quality, balance sheet management, and communications, suggesting a serious rethinking of the Fed’s role in managing the economy. While most of his task force members are solid picks, one or two have raised some eyebrows.

The task forces are… fine I guess, so long as they don’t paralyze Fed decision-making in real time. The problem is that the Fed under Warsh is not providing much in the way of guidance, and that appears to be on purpose. As the Wall Street Journal’s Nick Timiraos explained recently, Warsh is acting on his longstanding belief that the Fed had been saying and doing too much:

Warsh, a Fed governor from 2006 to 2011, has argued for more than a decade that the Fed’s forecasts breed conformity and its data are stale by the time policymakers see them. In a 2016 speech to economists, he questioned the precision the Fed claims in measuring inflation. After an external review he led of the Bank of England’s operations in 2014, Warsh lamented how the Fed’s decision-day discussions had become stilted recitations of prepared remarks—a shift that followed the Fed’s agreement to publish verbatim transcripts in 1993….

[Warsh] has said almost nothing about how the Fed reads the shocks now hitting the economy, or how policy should respond. Nor has he been more forthcoming in private: officials who sat through his first meetings came away without a clear sense of how he would approach the trade-offs ahead, according to people who have spoken with them. And where his colleagues describe a trade-off, at least in the short run, between fighting inflation and protecting jobs, Warsh denies there is one.

Several changes the task forces might steer the Fed toward—a modest reduction in its asset holdings, or retiring officials’ quarterly interest-rate projections—are “not a big deal either way” compared with the “more radical” step of declining to describe how the Fed responds to what it sees, said Jon Faust, an adviser to the last three Fed chairs.

For Warsh, saying less is a virtue. It protects the committee’s judgment. If policymakers issue a forecast, they start crediting evidence that confirms it and discounting evidence that doesn’t. He also believes a quieter Fed gets a cleaner read on what investors think about the economy, rather than hearing an echo of its own guidance. Investors “are upset with me already that I’m somehow not feeding them all the information they’d gotten before,” he told lawmakers. “My message to them is, ‘Play the ball, don’t play the Fed.’”

The thing is, so far Warsh’s results don’t seem to be validating his thesis. This week the bond market freaked the f**k out after Warsh’s last post FOMC meeting press conference, sending U.S. government borrowing costs to their highest level in nearly 20 years. That is, to use the argot of economics, real bad.

Axios’ Neil Irwin explains the problem:

In his press conference Wednesday, Federal Reserve chairman Kevin Warsh started by asserting that the central bank will not waver in its pursuit of 2% inflation. Then, he repeatedly declined opportunities to connect that commitment to any concrete action.

The result was a steep bond market sell-off, driving longer-term interest rates higher as global investors questioned the Warsh Fed’s willingness to raise the short-term interest rates it controls….

Warsh has long offered gauzy, high-level critiques of how the modern Fed operates. On Wednesday, he described candid discussions of the biggest conceptual issues for monetary policy. But he was elusive and vague on central banking basics….

Asked, for example, the Central Banking 101 question of whether the best remedy for stubborn inflation is rate increases, Warsh replied: “Is that the dominant remedy? If inflation continues to be elevated through the forecast period, interest rates could well be part of that solution, but I wouldn’t say it’s in isolation.”

When asked what inflation measure he is targeting, he began by offering the “proper, standard” answer that the goal is 2% inflation in the Personal Consumption Expenditures Price Index, before ruminating about “who knows” what may come after January….

“In Warsh’s press conference, he once again failed to specify how he intended to achieve his stridently asserted inflation resolve,” Michael Feroli, chief U.S. economist at JPMorgan, wrote in a note.

“He also cast doubt on whether PCE inflation will remain the Fed’s inflation target in the medium run,” Feroli added. “Both of these points raise questions about the new chair’s credibility in delivering lower inflation.”

The combination of Warsh talking but trying not to commit to anything is, well, weird. As Paul Krugman explained earlier this week, Warsh is spooking the most important audience he has: the bond market.

The bond market, the ultimate reviewer, really didn’t like Warsh’s performance. As the chart at the top of this post shows, the 30-year Treasury rate spiked and the dollar fell slightly. In plain English, this was the equivalent of bond market traders running for the exits….

Its reaction indicated that traders believe that there is a good chance that the Fed is going to keep rates too low for too long and thereby feed inflation. As a result, the Fed will eventually be forced to raise future rates to a higher level than if it acted to rein in inflation now.

So it’s clear that the bond market reaction wasn’t a judgment on the rate decision itself. It was, instead, a judgment on Warsh. In other words, Warsh’s remarks on Wednesday led the market to distrust his commitment to fighting inflation.

What could make things even worse is if rising levels of disagreement within the Federal Open Market Committee injects even more uncertainty into financial markets. And there is already some dissent. At this past week’s FOMC committee meeting there were three dissenting votes who wanted to raise rates — the most in over a decade. The WSJ’s Timiraos notes that Christopher Waller — a finalist for Warsh’s job — has already been challenging him on his task forces.

Warsh’s response to all of this has been to lean even more into opacity. According to the New York Times’ Colby Smith and Ben Casselman:

Kevin M. Warsh is considering reducing the number of regularly scheduled meetings at which the Federal Reserve sets interest rates, a potentially seismic move that would mark the most significant change in how the central bank operates in years.

The Federal Reserve’s 12-person policy committee meets eight times a year and votes on whether to lift, lower or hold borrowing costs. Mr. Warsh raised the idea of changing the frequency of those meetings at the Fed’s gathering this week, according to four people with knowledge of the discussion who were not authorized the speak publicly….

Reducing the cadence of the meetings — and, in turn, votes on rates — would be by far the most consequential change of Mr. Warsh’s tenure so far. It would mark a break from decades of precedent, reshaping the way the Fed steers the economy and potentially making it less responsive to changes in inflation and the labor market.

Meeting less often would also reduce the information available to Wall Street and the broader public about the Fed’s thinking about the path for interest rates, reversing a decades-long trend toward greater openness.

There is an internal logic to reducing the number of opportunities Warsh has to open his mouth if he’s not going to say anything that reassures jittery markets. Given the slow processes through which some monetary policy actions take to affect the real economy, however, this seems unwise. And, again, bond markets are not reacting like Warsh thought they would, which creates even more uncertainty.

Global political economy scholar Erin Lockwood explains the consequences of Wasrsh’s actions with a nifty 2x2:

Maybe this is all a transition phase. Markets might eventually adjust to Warsh’s approach. Or maybe markets will predictably react by trying to read Warsh’s tea leaves, leaving even more gyrations in monetary policy.

Developing…