Silence isn’t golden for a world looking to Kevin Warsh’s Fed

Since being sworn in as US Federal Reserve chairman on May 22, Kevin Warsh has struck a distinctly hawkish tone. At his first press conference at the helm of the world’s most important central bank on June 17, Warsh made a solemn vow to curb inflation. He said members of the Fed’s interest rate-setting committee were “unambiguous and unanimous. This committee will deliver price stability”. Bond investors who questioned Warsh’s inflation-fighting credibility – given that he built his candidacy for Fed chair on lower interest rates to persuade US President Donald Trump to nominate him for the role – are less concerned that he will yield to pressure from the White House to lower borrowing costs despite elevated inflation. Since the conclusion of the Fed’s policy meeting on June 17, the yield on the interest rate-sensitive two-year Treasury bond has risen from 4 per cent to 4.15 per cent. Bond markets are pricing in at least one interest rate increase by the end of this year. In a report on June 20, Citadel Securities said Warsh’s “hawkish tone confounded the expectations of many in the market who had predicted a ‘dovish-come-what-may’ approach and marked a substantive change from the [former Fed chair Jerome] Powell-era willingness to look through persistently above target core inflation and (arguably) excess sensitivity to the employment side of the mandate”. However, Warsh’s unanticipated hawkishness is likely to prove far less consequential than the sweeping reforms he has instituted at the Fed. Promising to embark on “a new chapter for the central bank”, Warsh said he had initiated an extensive review of everything from how the Fed communicates with markets to the future of its massive balance sheet and the reliability of its data sources. Not surprisingly, investors have zeroed in on the overhaul of the central bank’s communication policy. In a throwback to the more austere and opaque era of US monetary policy in the 1980s and 90s, the use of forward guidance – the central bank’s public communication about the likely future path of interest rates, largely aimed at guiding markets – has been jettisoned. The Fed’s post-meeting statement was the shortest since 2007, with the exception of the one accompanying the emergency cut in borrowing costs at the start of the Covid-19 pandemic. Warsh, who refused to submit his own forecast for interest rates, has been highly critical of forward guidance. In a speech in April last year, he said “once policymakers reveal their forecast, they can become prisoners of their own words. Fed leaders would be well-served to skip opportunities to share their latest musings.” The case for being a less predictable central bank has merit. Policymakers should not allow their hands to be tied by pre-committing to a particular interest rate path. As Christopher Waller, an influential Fed governor, pointed out earlier this month, the pledge to keep borrowing costs on hold during the pandemic contributed to the surge in inflation as the Fed fell behind the curve. Warsh is also right in calling for Fed officials to be more circumspect with their comments. A communicative central bank is one thing, but information overload is another. Fed policymakers “should not be acting like [Wall] Street economists, giving instant analysis of the data or appearing on business news shows. I cringe when I see a Fed official interviewed on Bloomberg, CNBC, et al”, Ethan Harris, a long-time Fed-watcher, said in a social media post on June 23. A hand-holding Fed breeds complacency and encourages recklessness. Trump himself has been a beneficiary of the “Fed put” – the presumption that the central bank will step in to support markets if asset prices fall too steeply – despite berating the Fed for keeping interest rates too high. However, even when the central bank was providing forward guidance, investors struggled to anticipate moves in interest rates accurately and were often blindsided by sudden shifts in policy. If the Fed goes radio silent, volatility will increase more sharply at a time when the artificial intelligence trade is faltering and hostilities in the Middle East are intensifying. First, Warsh still has a credibility problem. Although he sounds more hawkish, it is not clear how willing he is to push for interest rate increases, especially with US midterm elections approaching. The withdrawal of forward guidance could be a pretext for ducking hard questions about the need to tighten policy. Second, while scrapping forward guidance forces investors to pay more attention to economic data, it gives markets more influence in shaping expectations for monetary policy. Greater investor sensitivity to incoming data could easily trigger a disorderly sell-off, akin to the “taper tantrum” in 2013. Warsh should be careful what he wishes for. Third, the Fed is more than the US central bank. It has an unofficial mandate to preserve global economic stability. Warsh is underestimating the importance of the Fed’s global role. International investors need to understand how the Fed will respond to changing economic circumstances. A less transparent Fed is a problem for US bond markets and a major source of uncertainty in an already messy and unpredictable world. Warsh is right that forward guidance often proved counterproductive, but it is the Fed’s job to inform markets about the outlook for monetary policy, not the other way round.