On one level the much-anticipated speech of Fed Chairman Kevin Warsh at the Jackson Hole conference was not especially surprising. The key message, after all, was that with inflation remaining elevated, ‘we have work to do’. To investors, that sounded like an acknowledgement that interest rates would likely be heading up. And, given that inflation remains uncomfortably high, the Fed chair signalling that policy will be tightened to bring the growth of prices back inline with its target would not, normally, be especially unexpected.
But these are not normal times. Warsh’s start as Chair of the FOMC has come at a challenging time. He took over when the Fed itself had been subject to what, to many, seemed to be rising threats to the institution’s own credibility and independence from the White House. He is dealing with the fallout from an on-again, off-again war in the Middle East which is putting pressure on global energy prices and has the potential to drive a major inflationary shock. The sustainability of the AI-investment boom is, at best, uncertain. The jobs market is not sending clear signals.
And he has not helped himself. As the Center’s Finance Expert Panel noted at the beginning of his term, his less than conventional beliefs on central bank communications had the potential to cause confusion. This has proved to be the case. As this column noted at the end of last month:
In other words, investors cannot simply react to economic news without, on some important level, second-guessing how the Fed itself will interpret that news. The Fed can, if it so chooses, be more or less explicit about how it sees the future unfurling. But if markets do not have a sense of how the Fed is likely to react to developments, then risks of mispricing develop.
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What we investors have been left with is confusion. The Fed Chair seems to want to learn useful information from watching bond market moves, but those in the bond markets first need to learn something from the Fed Chair.
Until the reaction function is clearly set out, this confusion will continue.
As this useful Bloomberg chart demonstrates, Warsh’s speeches have been rather impactful on the bond market. But the reaction to his July press conference did not have the impact he likely desired.
Friday’s speech was better received. Mostly because, alongside the simple ‘we have work to do’, Warsh moved to address investor concerns. Without backing away from his desire to end the practice of offering forward guidance he attempted to set out what he sees as the Fed’s reaction function.
In an interesting section of the speech he set out six ‘principles’ and then moved to give his current assessment of how the economy looks in light of them.
Notable in particular was the principal that:
Third, there should be no misunderstanding: The Fed’s price-stability objective of 2 percent, as measured by the personal consumption expenditures (PCE) price index, is a firm, fixed target. Let’s be equally clear about another aspect of the objective: Price stability is not self-executing, nor is inflation necessarily mean-reverting. It is the Fed’s job to deliver stable prices.
Compared to the data:
The Fed’s preferred measure of inflation, the 12-month change in the PCE price index, stands at 3.7 percent, while the six-month change is 4.1 percent. The comparable measures from the consumer price index (CPI) are also elevated, as are the core measures of both PCE and CPI inflation. None of these measures are perfect, but they all tell a similar story: Inflation is running above our 2 percent target. So the Fed’s predominant focus right now should be on prices.
A cynic might argue that Chairman Warsh reiterated his views on the dangers of the Fed telling investors what it was likely to do before spelling out what it was likely to do at its forthcoming meetings. But even a cynic should be glad to have a clearer sense of the reaction function at work.
Of course Warsh’s well received speech is not the end of the game. As many bond market players have argued since Friday, talking the talk is one thing and walking the walk is another.
Acknowledging that the rates will, in all likelihood, have to head north in the meetings ahead is all well and good, but the Fed will likely need to follow through with this.
One immediate issue is that any hike before November’s mid-term elections will likely bring a verbal tirade from the White House and possibly more pressure on the Fed as an institution.
But a trickier problem is that the Treasury has, very unusually, begun a series of verbal and (small scale for the moment) policy interventions (possibly including its yen intervention) to bring down US longer term yields.
Alongside his distinctive views on Fed communications, Warsh’s other headline policy is to reduce the Fed’s balance sheet. Something which has the potential to put upward pressure on those very same yields.
Kevin Warsh’s time as Fed Chair is likely to stay tricky for a while longer.
