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This Warsh Guy Might Be a Keeper
A few weeks into the Warsh Fed Chairmanship, and there are a couple of changes that I think are worth pointing out. Both are subtle, and I present them as a longtime Fed watcher and rates strategist and Inflation Guy.
The first one is something I missed at first, until I heard it again. Warsh has been talking in terms of the Federal Reserve having a 2% inflation target or goal. This may not seem like much, since central bankers routinely pledge allegiance to that goal. But over the Powell term as Chairman, that went from being something concrete to merely vacuously aspirational. First, in 2020, the Fed abandoned a 2% target and instead implemented “Flexible Average Inflation Targeting,” or FAIT. That policy said that if inflation ran below (above) the 2% target, the central bank would adjust policy to allow it to subsequently run above (below) the target for a time in order to get the average back to 2%. Now, this presumes a fine motor control over inflation that the Fed most certainly has never demonstrated, and it also conveniently left out parameters such as the averaging period. But at least it was a strategy (ambiguous, but a strategy) rather than merely a goal.
Then, in August 2025, Chairman Powell announced that the Fed was abandoning the ‘make-up’ part of the strategy. So, the Fed would still target 2%, but only as an average over time, and if inflation deviated from that average, they wouldn’t do anything about it. I wrote about it at the time in “The Fate of FAIT was Fated.” It really helped highlight the flaccidity of the Powell chairmanship.
Yet, Powell continued to talk in terms of a 2% target. In my mind, that’s just going back to an aspirational, hypothetical goal. We aren’t trying to get inflation to 2% now, mind you, just over time. Over some unspecified amount of time. And if we try to lower inflation and can’t get it down, we just re-select the averaging period, I guess. If we were at 5% for a while, so you lost a lot of real wealth, and then inflation returns to 2%…well, then a year or so later the Fed says ‘see? The average over the last year was 2%. Sorry about all that other money you were counting on. That’s never coming back.’
Anyway, so Warsh has been referring to a 2% target. It’s not clear to me in what context he means that. In the original sense of ‘we respond when it deviates from that level’? In the current sense of ‘it would be nice, but we aren’t going to take any specific actions over any specific period’? Or does he mean to reinstitute a commitment strategy so that 2% means something? I sure hope it’s the latter, and I have certainly seen some signs that Warsh is a bit sharper than the last few Fed Chairmen, but until he says so I suppose we don’t know for sure. He could do worse than to systematically dismantle everything that Powell did…
The other change is large and obvious, but there is a subtle effect that I think is being missed and should be pointed out. Under Chairman Warsh, the Fed has moved to eliminate forward guidance. The number of speeches from Fed officials is probably likely to decline as a result, since that’s the only reason anyone goes to listen to a Fed speaker.[1] I have said a huge number of times that I think more opacity from the Fed is super important in helping to squeeze excess financial risk from the system. Other folks have made the same observation, and clearly Warsh agrees with this – he frames it in terms of giving the Fed more flexibility to change course when data changes, but the only reason that opacity does that is because in the alternative case there is a disincentive to change very much lest people think the central bank – gasp! – is unable to forecast the economy very well and is being surprised a lot.
But here is what I think people have missed. It is my belief that this change is also part of the Fed’s inflation-fighting strategy. Here is the mapping of my reasoning. Less guidance obviously produces more policy uncertainty, and I just pointed out that means it is prudent to carry less financial leverage. Another way to say the same thing, but focusing on individuals rather than institutions, is that increasing policy uncertainty leads to more demand for precautionary cash balances. Institutions respond to greater uncertainty and volatility by reducing risk. Individuals respond to greater uncertainty by holding more cash, so that they can respond to the increased vicissitudes of life – job loss, for example.
And that’s important, because an increase in the demand for precautionary cash balances implies lower monetary velocity, and lower velocity means a lower price level for the same level of money and output. This is a big part of why inflation did not immediately explode when the Fed and Treasury dumped trillions of dollars of liquidity into the economy almost overnight – people were scared and held a lot of that cash for a while, rather than spending the money. As we know, velocity eventually rebounded as people spent those balances down, and inflation resulted.
As a matter of fact, Economic Policy Uncertainty is an input variable into Enduring Investments’ model for money velocity. It is not nearly as important a variable as the absolute level of interest rates, but we can reject the hypothesis of irrelevance at the 1% level and it improves the fit of the overall model so it is economically relevant as well.
Again, I don’t really know if this is part of Warsh’s master plan, or just a fortunate outcome. But luck is the residue of design. For now, I’m hopeful this is more design than luck – but I will take it, either way.
[1] It isn’t like they are at all entertaining, even to an economist. Why would you subject yourself to a Fed speech, if there is no useful forward-looking content?!
The Fate of FAIT was Fated
Growth in the US is ebbing, and it is likely only the AI boom that is keeping us from recording a small recession. Unemployment is still rising, although slowly, and credit delinquencies are rising. Because the services sector and the goods sector are still asynchronous – a holdover from the COVID period – we haven’t seen an aggregate contraction, but it will happen eventually. That doesn’t concern me. Recessions happen. It is only worrisome because equity markets are so ‘fully valued’ that an adjustment to a recession could be rough. On the other hand, all signs point to the Federal Reserve starting to ease, and this may support stocks. I would go so far as to say that investors are counting on that.
That is a rather ordinary problem. The bigger problem has not yet been realized by equity markets, but as we look at long maturities on the yield curve we see that yields are near the highs of the year even with the Fed expected to ease. That is not normal. When the Fed eases the curve tends to steepen, because however long the period of lower short rates, it will be a larger proportion of a shorter-maturity instrument. But long rates still decline in that case, normally.
You can insert your favorite story here, about how foreign investors hate Trump, or people are worried about inflation, or the credit profile of the United States. My preferred explanation (see “The Twin Deficits – One Out of Two IS Bad”) is that if you reduce the trade deficit sharply but do not reduce the budget deficit equally sharply, then the balance must be made up by domestic savers and that implies a higher rate of interest.
There’s also some reason to be wary of the turn higher in inflation, even though that was entirely foreseen (see “Ep. 145: Beware the Coming Inflation Bounce”) and a good part due to base effects. There are, though, some signs of underlying secular rather than cyclical pressures on prices. For example thanks partly to AI electricity prices started accelerating higher in 2021 but unlike other parts of the CPI have continued to rise. The CPI for Electricity stands 35% above the level of year-end 2020, and well beyond the long-term trend. Beef prices are 41% higher and still rising.
Of course, there are always prices that are rising but there are two reasons I am more concerned about this now. The first is that the money supply has returned to a positive and rising growth rate and is at a level inconsistent with long-term price stability even before the Fed renews its easing campaign.
Five percent was once a nice level for M2 growth, when demographics and globalization were following winds. Now they are headwinds and we need to be lower. Still, I wouldn’t get panicky about 5%. Get to 8% and I’ll be more concerned. But the reason that might happen concerns changes happening at the central bank.
What gets the headlines is the continual pressure that the Trump Administration is putting on Fed Chairman Powell and others on the Federal Reserve Board, several of whom are jockeying to be dovish enough to be selected as the next Fed Chair. But the much more important development was the 5-year review of the Fed’s operating framework, which Powell discussed at his Jackson Hole speech. The significance of this was seeming lost on most investors, although 10-year breakevens have gradually risen and are up at 2.42%, and other than in the post-COVID surge they’ve not been much higher than that since 2012 or so.
These are 10-year breakevens, so this isn’t a tariff effect. What’s going on here? Not much, yet, but…there is the change in the Fed’s framework, which I think is important.
Five years ago, the Fed abandoned a specific inflation target in favor of “Flexible Average Inflation Targeting”, or FAIT, which basically said “we are targeting 2% inflation, but only over time. So when inflation is too low for a while, then it’s okay to let it run hot for a while later.” At the time, this was a clear sign that monetarists – who don’t necessarily believe there is a tradeoff between inflation and growth like the Keynesians do – were losing the battle. More flexibility to respond to inflation ‘tactically’ is not something that we needed, and it wasn’t clear how that would be a helpful change anyway.
But the current 5-year framework adjustment is worse. It basically abandoned the good part of FAIT, which was any kind of soft commitment to be hawkish in the future if necessary. In Powell’s words – and I’m not making this up – “…we returned to a framework of flexible inflation targeting and eliminated the ‘makeup’ strategy.”
Yep, that’s what he said.
There is a lot more in Powell’s explanation, but most of it all leans in the same direction. For all my historical criticism of former Chairman Greenspan, he deserves credit for this: he used to say that achieving low and stable inflation was key to achieving maximum stable employment over time. Thus, inflation was primary, not secondary, in achieving the dual mandate. Now, the Fed ostensibly wants to target a low level of inflation…because that’s what central banks are supposed to do…but recognizes that sometimes they’ll want to emphasize lower rates to help Employment – and the important part is that as I just noted, they won’t ‘make up’ for running too much liquidity now by running less liquidity later. Does anyone want to take the other side of the bet that the Fed will have an easier time lowering rates and keeping them low, than raising them and keeping them high? Accordingly, the long-term inflation outlook just got worse. I don’t think we are returning to the 1970s, but we aren’t returning to 2% any time soon – and the Fed is okay with that!
FAIT was never a very good idea, and I didn’t think it would survive the first time inflation ran too high and dictated an extended period of very tight money. It didn’t. I didn’t think they’d actively make it worse, and maybe the joke’s on me. They always make it worse.
Changing the Fed’s Target – FAIT non-accompli?
As the steadier measures of inflation (core, median, or sticky depending on your preferences) have started to overshoot expectations slightly – the y/y measures continue to decline, but slower than expected as the m/m numbers have surprised on the high side – the markets have continued to price Fed policy becoming increasingly easier over the course of 2024 and into 2025. While Fed officials continue to push back gently on this assumption, it seems that most of the FOMC is comfortable with the idea that there will be at least some decrease in overnight rates later in the year and the only question is how much.
While inflation has not been settling gently back to target, there have developed two big holes in the narrative that the Fed was depending on. First, there is no reason to think that rent of shelter is going to cross over into deflation, either in 2024 or any time in the future. The belief that the CPI for rents would follow the high-frequency data into deflation was never well-founded, despite some fancy-looking papers that claimed you could get three pounds of fertilizer out of a one-pound bag if you just squeezed it the right way (I discussed “Disentangling Rent Index Differences: Data, Methods, and Scope”, and why it wasn’t going to tell us anything we didn’t already know, in my podcast last July entitled “Inflation Folk Remedies”), and while rents are declining they are not plunging, and home prices themselves have turned back higher and are growing faster than inflation again.
Second, core-services-ex-rents (so-called ‘supercore’) inflation needed to see wages decelerate a lot in order for that piece to get back towards target. They haven’t, and it hasn’t.
This isn’t to say that these things may not eventually happen, but so far the expectation that we would get back to target sustainably by the middle of 2024 looks quite unlikely. Why, then, are people talking about when the first eases will happen? The only way that it makes sense to do so is if the goal to get inflation back to 2% sustainably is no longer driving policy.
This has led to some observers pointing out that the Fed doesn’t actually have a 2% target any longer. In 2019, the Fed moved to Flexible Average Inflation Targeting, or FAIT. Under this rubric, the Fed doesn’t need to regard 2% (or about 2.25% on CPI) as a target that they need to hit at a moment in time but only as an average over some period of time. This obviates the need for overly-aggressive monetary policy in either direction, such as the instantaneous adjustment linked directly to the inflation-miss that is required by the Taylor Rule.
Unfortunately, under that rule the Fed has little if any chance of meeting its mandate. It would have a better chance of hitting 2% in…um…let’s say a ‘transitory’ way, as rental inflation swings lower and we pass close to the target briefly before inflation goes back up to its new equilibrium level. Back in August 2021 I noted that the Fed was already above the FAIT projected from the announcement of that policy, and in fact had used up all of the post-GFC slack. Obviously, it has gotten worse since then. Below, I update the two charts from that article. The first chart shows the CPI from August 2019, along with the average-inflation-targeting line and the forwards suggested by the CPI swap market (showing where inflation futures would be trading, if they were trading).
The second chart shows the CPI back to January 2013. We’ve made up all of the inflation from the post-GFC deflation scare, and then some.
Note that the inflation swap market is not indicating any expectation that prices will return back to the trendline. The market is acting as if the Fed is still operating under the old rules, where the goal was to get inflation to be stable at 2% from here, wherever “here” is. This means one of four things will have to happen, or it implies a fifth thing.
- The Fed needs to re-base its FAIT to start from the current price level. In that case, the red CPI-plus-2.25% line will shift abruptly upward but then will parallel the inflation implied by the inflation market; or
- The Fed can keep the original base, but concede that the actual target now is 3% (about 3.25% on CPI), which means that if the inflation market is right then it should be back on target by late 2029 (see chart); or
- The Fed can dedicate itself to fighting inflation for much longer, and publicly disavow the notion of reducing interest rates in the next few years. If CPI went completely flat then the Fed would be back on the line by sometime in 2028.
- The Fed can abandon FAIT, because it has become inconvenient, and validate the inflation market’s assessment that the Committee would be happy with 2% from here, not on average.
If none of these things happens, and the Fed then implies that the inflation market is going to permanently imply something different from what the Fed claims to be its modus operandi. In that case, it would be very hard to argue that the central bank had not lost credibility, wouldn’t it?
