Does Inflation Targeting Square with the Chair’s Disposition?

The Fed’s policy decision to leave interest rates unchanged in late July was effortlessly absorbed by fixed income markets, which is just how it should be. Interest rate changes should be non-events and are so because the market knows both that central bank strategy is to deliver 2.0% inflation and how it achieves it. And we have arrived at this happy place because central banks long ago adopted transparency in their operations.

Transparency is saying what you do. Credibility comes from doing what you say. To judge any central bank’s credibility, we need to know how it achieves its goals.

While the policy decision was well received, Warsh’s stumbling press conference was met with a surge in long-term borrowing rates and his performance was largely panned. Warsh’s awkward performance can be traced to his Fed critique set out in prior writings and speeches. He has both dismissed forecasting as pointless and suggested that less communication is more, with the latter intended to restore a sense of risk balance in the fixed income market.

Prior to becoming Fed chair, Warsh had some harsh things to say about the day-to-day management of Fed interest rates but now he is Chair he finds himself boxed in by his preannounced position.

In a speech to the Group of 30 in April of last year he said, “I do not find the current Fed policy of ‘data dependence’ of much real value. We should care little about two numbers to the right of the decimal point in the latest government release.” It’s one thing to carp from the sidelines; it’s quite another to be in charge of Fed communications when forecasting is a necessary condition for meeting the inflation target.

Delivering the inflation target of 2.0% demands a forecast of the interest rate path that the central bank believes has the highest probability of meeting 2.0% over its forecast horizon, roughly two years ahead.

How good an inflation targeter you are depends on how good an interest rate forecaster you are, and interest rate forecasting is essential because there are lags between changing interest rates and the impact on first demand (nine months) followed by inflation (eighteen months to two years later.)

The interest rate forecast is both a guide and an anchor that minimizes inflation drift from its target. Central banks do not have perfect foresight, and they will make forecast errors. But they react to those errors by revising their interest rate forecast, followed by an interest rate change – either up or down. Interest rate changes are contingent on the change in information, or surprises to your interest rate forecast.

When the market knows this operating model – or it knows the central bank’s reaction function – policy changes can be anticipated, and confidence in the inflation target maintained. The market should not be surprised when outcomes are different than forecast, but any change should be explained.

Communicating the contingent nature of policy is essential for the smooth functioning of capital markets. The smaller the magnitude of surprises, the smaller the market’s uncertainty about inflation remaining near 2.0% and the smaller the deadweight loss the economy must shoulder.

The Fed needs a forecast to do its job, but it does not need to share the details of the forecast with the market for fear of it becoming a commitment. This notion I share. But you can’t meet an inflation target if you don’t have a forecast to guide you. If you have no truck with changing interest rates in response to a changing interest rate forecast, then what is the alternative?

If instead policy is made in response to today’s inflation rate rather than the inflation forecast, then the interest rates necessary to bring inflation to target will be higher, stay higher for longer, and cause more volatility in both interest rates and the real economy.

You can see why the press conference quickly went off the rails and the bond market repriced.

Outsourcing Policy to the Market

The Fed Chair’s message was basically that after doing nothing there was nothing to say. More to the point, he seemed to say that the interest rate changes necessary to meet the inflation target had been outsourced to the market. One wonders if Kevin Warsh is the dog that caught the car.

Outsourcing inflation control to the bond market would be a serious error. The one thing that the central bank can deliver with confidence is inflation at a rate of its choosing, and it does so by moving demand around relative to supply. Too much demand? Raise rates and bring it down. Too little demand? Move rates down and give it a boost. The bond market cannot deliver low inflation with such precision, so it is not clear that the bond market is even qualified for the job.

While Warsh has definitely boxed himself in by his prior public record on communication and forecasting, one has to wonder if he understands the Fed’s reaction function. Moreover, he seemed doubtful that inflation can be controlled by moving interest rates (up in this case.) This is astonishing for a central bank governor; quite curious one might say.

Forward Guidance vs Saying What You Do and Why

Forward guidance emerged in the post-GFC world, where interest rates were constrained by the zero lower bound and the interest rate forecast was flat as far as the eye could see. Central banks wanted a flatter yield curve, and to get it they told the market that it should not price central bank tightening for some time – the next nine years, it turned out.

Forward guidance then was appropriate, but Warsh is entirely correct that its time has come and gone. But you still need to talk about the decisions you make and why you have made them when interest rates go up, go down, or do not change. If you leave a communications vacuum, someone else will fill it, often in ways that are unhelpful. Unanswered questions emerge like has the target changed, has the strategy has changed, is there is a new operating procedure?

Ending the sin of forward guidance does not demand an end to the communication of decisions.

Changes in the Distribution of Outcomes

Financial markets are important expectations processing and transmission mechanisms. So discerning the forces driving large movements in asset prices is important, especially when those forces are not driven by a change in underlying economic and financial forecasts.

The market’s reaction to the Fed decision last week was benign; it didn’t signal a change in the market’s modal or most likely forecast for growth and inflation over the Fed’s near-term policy horizon. Bond markets did react to the lack of information in the press conference by steepening the yield curve, signalling concern about how inflation is being managed.

Strangely, Warsh indicated he was comfortable with this outcome suggesting the market had stepped-in to do his job for him. This is folly because the bond market prices what the Fed is likely to do not what it should do.

Paul Samuelson suggested that a central bank looking to market prices to tell you something valuable is not useful. He called it the monkey in the mirror. When a monkey sees its reflection in the mirror, it sees another monkey, not its reflection. Warsh didn’t see a market asserting control over inflation in the mirror: he saw his performance in the mirror. And it has been a long time since inflation was at or below 2.0%

Only the central bank owns inflation control, and if the yield curve is steepening in response to a central bank governor’s comments, then the governor is in danger of losing the confidence of the market.

Growth & Inflation are the Two Big Asset Risk Drivers

Economic factors and the policies governing them are the drivers of the major trends in capital market asset prices. An emerging loss of confidence in the central bank is not a trivial issue. While it is too early to change the modal forecast in response to a difficult communications event, it is not too early to reprice the left tail in the expected return distribution.

The bigger impact on all asset prices comes when the modal forecast changes. This is now a risk that needs to be taken seriously, as beyond the communication challenge a three-person dissent in favour of higher interest rates is a big deal. This divergence of opinion should have been explained.

Interest rate decisions are still made on the weight of FOMC votes, but whenever interest-rate decisions are made they should be explained regardless of whether the decision is up, down, or no change.

Data lead words and words lead action. What data led the three dissenters to their vote? Why did others not share their concerns? Why were potential questions not anticipated, and why were responses not prepared? These are questions the Chair should have prepared for in his G30 speech he indicated indifference to changes in data.

In isolation, this monetary policy disturbance doesn’t change the most likely outcome; it merely shifts perceptions about both the probability and scale of a potential loss of inflation control priced in the tails. But it still matters.

Policy Slippage & Asset Repricing

Central bank independence has been a stabilizing force when the independence of other institutions has withered in the heat of politics. Chipping away at Fed independence threatens a sizeable repricing of a US economic regime or superstructure, one that would deliver a significant destabilizing repricing of the modal outlook well beyond tail repricing.

The dominant asset pricing risk factors are growth and inflation and are common to all asset prices. Just as successful central banks need to be good forecasters, successful investors also need to be good forecasters. They don’t need to be perfect, just good. This means that investors need to have a handle on what the next move in asset prices might be, and if the Fed isn’t doing its job well then the repricing could be big.

Before we position for a big modal forecast change, we have to determine whether Warsh’s awkward communication was by design or accident. Does it signal a major change in strategy and tactics, or was it a rookie mistake?

Diversify & Derisk

Given that long-run asset return correlations that underpin mean-variance optimization are unstable, and that asset return volatilities are unequal, the shaky ground underneath US inflation targeting in the context of stretched asset values suggests it’s time to diversify and potentially derisk as a way to recognize a fattening in the left tail of the return distribution.

Adding alternative inflation-protection assets helps compensate for one of the key risk factors – inflation – but it leaves you exposed to growth. Seeking returns to uncorrelated risk factors helps, and structuring downside protection is worth consideration if it can be done cheaply.

Emotional, chaotic, and extractive trade policy has shaken but not stirred the foundation of the US$, and US policy errors will continue to be transmitted globally limiting the diversification advantage of non-us asset markets.

Global-macro investment opportunities come when investors get ahead of a change in consensus pricing. Price changes lead the changes in market forecasts because investors adjust to the change in their assessment of the probability distribution of outcomes by prepositioning to capture the coming change in the consensus. The central forecast thus changes in response to investor actions led by price action.

Monetary regimes come and go over time, and it is highly likely that inflation targeting will give way to a different regime at some point in the future as it may not meet the moment. The catalyst may well be failure to deliver inflation at target—and neither all-items CPI nor core CPI has been at or below 2% since March 2021, even if the Fed’s formal target is defined in terms of PCE inflation.

Inflation targeting continues to meet the economic moment but there is some doubt whether it meets the political moment. Some commentators ascribe Warsh’s rudderless press conference to his subordination of policy communication to the satisfaction of Donald Trump.

Faith is belief in the absence of evidence, but can one have faith in the Fed to deliver 2.0% in spite of the evidence? It would be reassuring if you believed the Chair misunderstood the appropriate reaction function and would soon learn. But if he doesn’t, then does he have a new regime in mind other than inflation targeting? In a world of creeping fiscal dominance, this is no trivial question.

Any new central bank governor faces a challenge. Typically the question is whether in the policy transition the policy leaves with the man or woman. That challenge would easily have been put to bed by nudging interest rates higher to bring inflation back to target, with a clear message communicated afterwards.

Inflation at its 2.0% target is becoming an ever-smaller dot in the rear-view mirror and on current price trends, sustaining inflation credibility will demand action.

One swallow does not a spring make, but Warsh needs to understand the difference between forward guidance and his role in explaining management of the current conjuncture. If you aren’t crafting the narrative, then someone else is. And that can be costly.