So far, the new Federal Reserve (Fed) Chairman Kevin Warsh seems to have things firmly in hand. Despite a lot of public disagreement on interest rate policy among Fed board members and regional Fed presidents, he managed to get a unanimous 12 – 0 vote at the June meeting of the Federal Open Market Committee (FOMC) to hold interest rates at their present levels.
Because Warsh has big plans for changing the way the Fed thinks and does things, he will continue to need talent whipping his colleagues into line. Though Warsh’s plans for what could amount to a monetary revolution will doubtless proceed at a more sedate pace than, say, the script of “Les Misérables” would prefer, it will nonetheless face stiff resistance, enough perhaps to thwart Warsh’s objectives. Still, all financial people need to know the directions the new Fed chair means to take things.
Warsh Breaks From the Fed’s Forward Guidance Playbook
Warsh has already exhibited one aspect of his new Fed at the traditional post FOMC press conference. There, reporters pressed him to declare future policy directions, whether, for instance, the Fed was thinking about more restrictive policies to fight inflation or easier policies to boost the economy. Fed chairs for years now have eagerly given reporters this vital copy for their FOMC stories. Warsh refused, not to make life difficult for media representatives (though he managed to do that), but because he believes “forward guidance,” as such declarations about the future are called, serves financial markets badly. The belief is no doubt why the June meeting’s writeup carried less detail and was considerably shorter than in the past.
Forward guidance has been standard for more than a decade. It began with Fed Chairman Ben Bernanke in 2011. Bernanke reasoned that financial markets, if they know where the Fed was headed, could better position themselves to cope with that future. Warsh sees matters differently. Part of his reasoning refers back to the stress he has long placed on the need for humility. While praising the Fed staff and its forecasting talent, he has stressed repeatedly in his writings that no one, no matter how talented, can see the future. When the Fed tells people what it plans to do, it implies that it knows what it will need to do in the future – in other words that it knows the future. It cannot, and because of that brutal fact, policy from time to time will have to shift in order to cope with environments other than those expected and accordingly render any previous forward guidance entirely misleading.
Warsh points out yet another danger. When the Fed gives its forward guidance, almost all market participants position themselves according to it. When, as inevitably happens, the Fed’s former plans no longer suit reality and it has to shift policy, markets, largely positioned for what the Fed had previously said, will have to shift. And because market participants had taken the Fed’s forward guidance on board, the shift will occur en masse amid inevitable and unnecessary turmoil. If, however, the Fed admits that it can’t see the future and cannot tell people what it will need to do, market participants, Warsh argues, will position themselves in a diversity of ways and only some will have to shift in response to future policy changes, reducing the amount of market turmoil.
Five Task Forces Signal the Scope of Fed Reform
With this and other changes in mind, Warsh has already established five so-called “task forces” at the Fed to consider reforms. One of these task forces comes under the heading “communications.” Its broad mandate is to make recommendations on how the Fed should communicate with media, market participants, and the public. Its focus is largely to deal with this matter of forward guidance. The four other task forces come under these headings: the Fed’s balance sheet, the fundamentals of inflation control, data sources, and how the Fed can account for the sea change in productivity implicit in the development of technology generally and artificial intelligence (AI) in particular.
Reversing Quantitative Easing and Shrinking the Balance Sheet
Use of the Fed’s balance sheet as a tool of monetary policy, known as “quantitative easing,” was also introduced by former Chairman Ben Bernanke. He resorted to it first during the financial crisis of 2008. In that urgent situation, the Fed had already reduced interest rates to zero and needed to take additional steps to bring financial liquidity to beleaguered banks and other financial institutions. It did so by buying treasury and mortgage-backed bonds directly on the open market. Warsh, who was at the Fed at the time, endorsed the practice as an emergency measure.
Once the emergency passed, however, Warsh wanted the Fed to reverse the practice. Instead, policy makers continued to buy securities on the open market, enlarge the Fed’s balance sheet, and pour liquidity into the financial system. Warsh claimed that the practice facilitated excessive government spending and bond issuance and so led to the inflationary pressures of 2022, the legacy of which still troubles the economy. Warsh resigned over the matter. He still sees it as a way of monetizing the excessive use of government borrowing and is inherently inflationary. His task force will presumably indicate the least disruptive way for the Fed to reverse the effects of past quantitative easing, shrink the Fed’s balance sheet, and abandon the practice.
Why Warsh Prioritizes Inflation Control Over the Dual Mandate
Warsh has made clear repeatedly in his writings that he considers inflation control the Fed’s main objective. He is well aware that Congress has given the Fed a dual mandate, adding full employment to its inflation focus, but Warsh argues that fiscal policy and regulatory reform affect employment and overall economic growth much more directly than monetary policy. The Fed, he has argued, can best serve the needs of full employment and economic growth by ensuring price stability. His task force presumably will specify what the Fed can do and how to serve these economic needs within the general parameters set out by Warsh’s perspective.
Rethinking the Fed’s Data Sources and Methodology
Task force four will “evaluate new information sources and methodological changes.” At present and for a long time, the Fed has relied almost exclusively on the economic statistics collected by its own researchers and those at the Commerce and Labor Departments. Without criticizing these statistics, he and others have long recognized that they are at best only an approximation of what is happening in the economy and on financial markets. Warsh has pointed to the immense revisions in these data over time as indicative of how misleading they can be at times. He would supplement these statistics with real time market and business information. Presumably, his task force will investigate where the Fed can glean this information and how it can incorporate it into its decision making.
AI and Productivity: The Fed’s Most Open-Ended Challenge
The fifth task force will take up AI, potential sea changes in productivity, and the economy’s growth potential. Of the five efforts, this is the most open ended and vague. Warsh, like most people, understands that AI and other technologies can influence productivity in the economy and its fundamental growth potential. These prospects greatly complicate the formulation of monetary policy. The Fed needs to know the economy’s growth potential to avoid policy mistakes. If for some reason the economy surges ahead of its potential, the Fed might want to pursue a more restrictive policy to avoid economic overheating and inflationary pressure. But if that surge reflects a technological breakthrough that will create a sea change in the economy’s growth potential, monetary restraint could inadvertently slow the pace of investment in these new technologies and accordingly stifle beneficial economic trends. It is not an easy task to get a good fix on such matters, but it is encouraging that this new Fed chairman recognizes the need and wants it incorporated into policy making.
A Greenspan Comparison, With Reforms Still to Come
Warsh has been compared to the late, great Fed Chairman Alan Greenspan. Like Greenspan, he has entered the role with powerful theoretical underpinnings and much practical experience. Of course, in monetary policy—as in every aspect of economic policy—nothing is definite, and many who have grown comfortable with the old ways of doing things will resist Warsh’s efforts. But his beginning offers some assurance that future Fed policy making will at the very least become increasingly thoughtful and effective.
