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There Are Warsh Things I Could Do
Honestly, I feel like I would really like to write about something other than new Fed Chairman Kevin Warsh. Because it feels like everyone is writing about him, and about his remarks at Jackson Hole. What I found remarkable was that his comments actually seemed to have relatively little effect on markets, compared to prior Fed Chairmen. I’m pretty sure that’s by design, but what is really fascinating is that while what he said seemed pretty clear to all pundits every one of them seemed to have a different read. It’s like the old story of the blind men touching an elephant and coming to different conclusions about what they were touching depending on whether they had encountered a leg, a trunk, or a tail. Or perhaps he is just channeling Greenspan, who famously said during Senate testimony “If I seem unduly clear to you, you must have misunderstood what I said.”
With a heavy sigh, let me apply my own three-and-a-half decades of Fed watching to Warsh’s Jackson Hole speech. In doing this, I’m not trying to assess the likely course of interest rates per se: I’m just trying to assess whether Warsh is still heading in the right direction to restore inflation-fighting credibility to the Federal Reserve. (Given the inflation outcome since 2020, if you still think the Fed is a credible inflation-fighter then please explain to me what would need to happen for the Fed to lose credibility! With friends like that, we don’t need enemies.)
Here we go.
Artificial Intelligence (growth and inflation effects)
Warsh starts with his own pet cat, the rise of Artificial Intelligence to be economically and financially significant. One thing I already appreciate about the Chairman is that he has a tendency to ask the right questions. We will find out later if he gets the answers right, but if you start with the wrong questions – as prior Fed Chairmen have done for a while – then you’re unlikely to get the answers right.
Here is the right question: “Will the application of AI cause a significant, sustained rise in productivity across the economy? And if so, when? Will token usage be complementary or competitive to labor? Will the next generation of AI models demand even greater capital intensity, or will the models themselves help devise a capital-light solution?”
Warsh mentioned Moore’s Law[1] in his musings. Now, while I think that AI is already reaching some pretty difficult barriers to future exponential growth – for example, the pushback against data center construction and the resource (electricity, water, etc) stress that comes from such growth – Warsh’s mention of Moore’s Law brings up a pretty important caveat to that. If the computing power consumed by AI stayed constant, its energy use would be expected to decline rather sharply over time because of Moore’s Law; so, all that really needs to happen for AI to continue to grow in importance without befouling the planet is just for it to slow down its growth rate a little. Yes, that will suck for the stock prices of AI-involved companies but it isn’t the hard wall I was starting to think it was.
More interesting to me, when we think about AI’s impact on growth and inflation, is that the assumption seems to be that AI will somehow be even more impactful than the rise of the internet and world wide web, and the rise of computing generally. Those were massive innovations of the last 50 years that did not meaningfully impact inflation or growth…as far as we can see in the data. Innovation is normal. Breakthrough innovation is normal. It needs to be an order of magnitude more impactful than the Internet to be noticeable, and if it gets to that point then we need to watch out for Skynet.
Forward Guidance
Warsh’s analysis of the constrictions of forward guidance is right on point, when he notes that the more forward guidance the Fed gives, the more they box themselves in. That’s why he is going to stop it. What’s amazing is how few people recognize he is just channeling the Dread Pirate Roberts in this.
Reporter: “What is the Fed going to do?”
Warsh: “Nothing of consequence.”
Reporter: “I must know.”
Warsh: “Get used to disappointment.”
Humility in the Face of Uncertainty
It is weird to think of anything going on in the Eccles building that we could brand with the appellation “humility.” It is so refreshing!
“So, if forward guidance is ill-suited to normal times, then how about the new Fed chief commits—at the very least—to an explicit reaction function? Surely, he should tell us his interest rate path—if, say, the data were to come in hot or cold.
“I wish our understanding of the economy were so precise as to provide a mechanical, tried-and-true answer—that some simple function like a Taylor rule could be rigorously relied upon. But our knowledge just doesn’t extend that far—at least not yet—and the factors most relevant to the proper conduct of monetary policy change over time…
“In my term as Chairman, my colleagues and I will endeavor to construct more reliable models and more robust rules to guide policy decisions. We’ll do this knowing that accuracy in economic forecasting is still just an aspiration. With so much changing so fast in geopolitics, global supply chains, and technology, it’s wise to be modest about what we can and cannot know.”
Wow. I just want to slobber over this because it’s my own pet cat.[2] It’s something I’ve been saying and writing about since the late 1990s – indeed, I even wrote about it in Maestro, My Ass!, as an argument for why the Federal Reserve should be much less active than it was and has remained. The idea is that in general, because economic data is an imperfect measure of the underlying economic reality, and subject to massive error bars, it’s hard to reject the null hypothesis that whatever we previously thought about the economy hasn’t changed, with the introduction of a new data point. Ergo, the Fed should have quite a high bar for moving policy off of neutral, and in general shouldn’t do much. Plus one for Fed credibility!
The Fed’s Price Target
“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.”
This is huge, but most people didn’t notice it was huge because they totally missed the fact that the Fed under Chairman Powell had first moved to “Flexible Average Inflation Targeting” (FAIT) …and then at the Jackson Hole colloquium last year Powell told the world they were removing the “makeup” strategy. Effectively, that mean there was no ‘target’ in the sense that the Fed would watch inflation, but not try to achieve any particular average inflation. Warsh’s declaration means that FAIT is dead. He took a much more direct path. FAIT was implemented because the Fed realized they weren’t very good at targeting inflation. Warsh simply did away with the smokescreen and said ‘yeah, we’re not very good at forecasting.’ Plus one for Fed credibility again!
Short-term Interest Rates
I don’t love this:
“Fifth, short-term interest rates are the predominant tool to achieve the dual mandate.”
You don’t cause scarcity by moving the price. You move the price by causing scarcity (of reserves). Moving interest rates, instead of adjusting reserves (which has a side-effect of moving interest rates), is backwards. I thought Warsh knew that, and he seems to say other things that indicate he does. But in the meantime, minus one for fed credibility.
Money Matters
“Sixth, money matters. It’s not fashionable these days, but my view is that money has something important to do with monetary policy.”
This is about as unpopular a view in academic monetary policy circles these days as there is. But he’s right! Plus one again. And if money matters, it suggests the Fed might prefer to adjust money and let interest rates happen organically than adjust interest rates and let money growth happen spontaneously. You can’t do both, without a whole lot of difficulty.
Wages and Prices
“The data also show moderate wage growth. But in tracking underlying inflation, wage growth has not proven a reliable indicator of future inflation for a very long time.”
Another pet cat of mine: obviously wages follow prices. Shiller pointed out decades ago that if inflation went up after wages went up, everyone would love inflation. But we all know that inflation sucks, since prices go up and then if we’re lucky the boss man will give us a cost-of-living adjustment. It does not happen proactively. It’s fiendishly difficult to prove that with data, but the burden belongs to people who propose a non-intuitive result. Warsh is right. Plus one again.
Big Finish
“Here is my standard: We must be confident that underlying inflation is moving to our objective, clearly and at sufficient speed. Otherwise, we have work to do.”
This is where people concluded ‘the Fed is going to raise rates!’ But this statement, in the context of this speech especially, does not imply that at all. Shrinking the balance sheet is work that has not yet begun, but needs to be done, and frankly needs to be done first, before worrying about modest changes in short-term policy rates. Shrinking the balance sheet, of course, will cause market interest rates to rise (make the largest buyer of Treasuries, the Fed, into a seller. It would be weird if something else happened). Which, if long-term interest rates really do matter to inflation, checks that box without moving policy rates.
Now, the Federal Reserve may indeed hike policy rates. The Federal Open Markets Committee is after all a committee, and while prior Fed Chairmen basically got to pick the direction of travel Warsh has two disadvantages that imply he might have to give some to get some. His first disadvantage is that President Trump appointed him and likes him, and to certain FOMC members that means that whatever Warsh wants, they want the opposite. Especially if it hurts Trump. His second disadvantage compounds with that: he is trying to effect real change, and ossified institutions hate change and actively resist it. It isn’t clear to me yet whether Warsh is going to win or not. His appointments to the Inflation Frameworks Task Force were not encouraging, but maybe that’s part of his compromise to win people to his side.
All I know is that so far, I like him and I think he can make the Fed a much-improved institution. His Jackson Hole speech is consistent with what we have heard so far – and that’s encouraging.
[1] Moore’s Law was expounded by Gordon Moore, Intel’s founder, in 1965. As amended in 1975, it states that the number of transistors on a microchip, and thus computing power, doubles every two years.
[2] Since I’ve now used this twice, I guess I should define it. “Pet cat” is used in sports to refer to a player, usually a minor or unknown player in training camp, that a writer or coach advocates aggressively for. The term was popularized by former NFL Coach Bill Parcells, who would mock reporters asking about such players by asking if that player was the reporter’s ‘pet cat’, living at home with them. So a ‘pet cat’ is like the opposite of a pet peave.
