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My Views on Kevin Warsh as Fed Chairman
I promised last week that I would give you my views about Kevin Warsh. I did so while clearly forgetting that I already have. Having heard more from him, though, I can put more meat on that bone.
I must first tell you that I have a natural tendency to want to believe that our monetary policy institutions can be saved, and so I want to believe that each new Chairperson has a chance. I was optimistic, for example, about Powell (and to be fair he was a definite improvement over Bernanke and Yellen!) even though in the end he turned out to be a fairly normal Fed Chair. I do give him credit for responding to the COVID spike a lot faster and further than I thought he would, especially since he claimed to believe the inflation was transitory. He didn’t do it right, but at least he wanted to.
My hopes, though, have generally proved to be unrequited. In my opinion, the Fed has been in a downward spiral since 1987 when Alan Greenspan took over. I once wrote a book called Maestro, My Ass! and I do not apologize for it. Although we look wistfully on the Greenspan days now, he started several trends in central banking that have been very destructive – the main one being his mission to make the institution’s deliberations and thought process very transparent. But at least he viewed inflation as the primary policy target.
This introduction is meant to point out that while I really want to believe that monetary policymakers eventually learn lessons and course-correct to doing things the right way, I’m no apologist for the Fed. You’ll want to remember this when my enthusiasm for Kevin Warsh comes out, below. Here is my framework – my basic views, expressed ad nauseum on this blog over the years, about central banking and the conduct of monetary policy:
- Monetary policy is best conducted with as little transparency as possible. It is not the Fed’s job to make the water always warm and inviting for investors so that they can lever up their returns without fear. Transparency breeds complacency and causes excess leverage in markets. As I said in ‘Maestro’: make people dig their own foxholes, and they will dig them deep enough.
- The Fed has a truly terrible forecasting record when it comes to inflation, especially. I do have to say that there are some signs of improvement on that score, so maybe the reason it has been so bad for so long is that for 25 years there was nothing to forecast since inflation was fairly low and fairly stable; now that it’s worth researching, maybe they’re learning. Some. But the fact remains that the forecasts are not even remotely good enough to base monetary policy on.
- Because economic data has huge error bars, and gets revised a lot, and forecasts have even larger error bars, it is nearly impossible to reject the null hypothesis that ‘nothing has changed’ with any given data point. It takes a long time and a lot of data to truly overcome the confidence hurdle. Since monetary policy is such an overpowering tool, it generally should be used very sparingly. The Fed should only rarely move rates away from neutral, and only when the cause to do so is undeniable. Yes, this means they will be late. But that’s okay – see point #1 – if people know that they can’t rely on the central bank to save them.
- One of the wisest things Greenspan ever said was that with respect to the dual mandate of price stability and long-term economic growth, the condition of “low and stable inflation” is the environment most apt to produce high long-term economic growth. In other words, the inflation-fighting mandate is primary, and the economic growth goal is secondary – and best achieved by means of achieving the first goal.
- Interest rates have no identifiable causal (lead) effect on inflation.
- Inflation expectations are a result of, not the cause of, inflation.
- The stock of money per unit of GDP is pretty much the only thing that matters for the price level in the long term. (Here is an article with a few of my favorite charts.)
- The implication of 4, 5, 6, and 7 is that the Fed should focus almost exclusively on maintaining money growth at a low, steady pace. This job is hard enough with the proliferation of alternate forms of money!
Now, let’s compare this to what Hopefully-Future-Chairman Warsh said in his confirmation testimony last week.
- Inflation is primary: “Congress tasked the Fed with the mission to ensure price stability, without excuse or equivocation, argument or anguish. Inflation is a choice, and the Fed must take responsibility for it.”
- The Fed should reduce forward guidance. I personally would say eliminate. I’m not entirely clear if Warsh’s desire to reduce forward guidance is because he doesn’t believe the Fed is good enough at forecasting to provide good guidance, because he thinks that too much transparency leads to overleveraged personal, corporate, and financial balance sheets, or because he doesn’t think that the Fed gains anything by trying to restrain inflation expectations. It doesn’t really matter. All three reasons are good. Any one of them is sufficient. If Warsh wants to reduce forward guidance, he’s on the right track.
- He thinks the FOMC should meet less frequently! I love that – again, I’m not sure if his instinct to do it is because he doesn’t think the Fed should be so active, or because he doesn’t think the data changes enough in a month and a half between meetings, or because he wants to be less transparent. Again, all three reasons are good.
- Warsh seems to be a believer in the notion that the rise of AI will pressure inflation downward. I do not share this view (see my article here and by podcast here), although I am a wild fan about Claude. I may be wrong. Warsh may be wrong. The important point here is that Warsh seems willing to wait for evidence, rather than conducting policy as if the Fed’s models about what could happen was in fact evidence. This is wisdom. I am absolutely content to be optimistic about the effect of AI right along with Warsh… as long as we don’t adjust policy on the basis of a guess.
- In general, Warsh seems to believe that the Fed should be less-active with respect to interest rates; he has also expressed an opinion that the Fed’s balance sheet should be smaller and is a general skeptic about relying on the balance sheet to adjust monetary policy. Unlike many at the Fed, he thinks the size of the balance sheet is related to the level of inflation and interest rates. He is absolutely correct about this and it may be fair to say that this is one of monetarists’ core objections to how monetary policy has been conducted since Bernanke. Warsh dissented on QE and LSAP (large-scale asset purchases) back during the Bernanke days. Shrink the balance sheet, and that will let you lower interest rates a little bit as inflation recedes. Absolutely. When the Fed shrinks its balance sheet – which was first expanded in an effort to stave off deflation; remember Bernanke’s helicopters? – it will reduce upward pressure on money growth and that will directly slacken upward pressure on inflation.
I don’t know if Warsh can pull off such a monumental pivot. Institutions resist change, and the Federal Reserve is a big institution. But it is a pivot worth making! If Warsh succeeds (and if I’ve correctly laid out his views), it will restore the Fed to at least its mid-1980s glory. Well, maybe “glory” is a bit strong…but this is one case in which going backwards would be a drastic improvement.
The Powell of Positive Thinking
Yes: Federal Reserve Chairman Powell was very hawkish at his Congressional testimony on Tuesday and Wednesday. He clearly signaled (again) that once Fed overnight policy rates reach a peak, they would not be declining for a while. He additionally signaled that the peak probably will be higher than previously signaled (I’ve been saying and thinking 5% for a while, but it’s going to be higher), and even signaled the increasing likelihood of a return to 50bp hikes after the recent deceleration to 25bps.
This latter point, in my view, is the least likely since all of the reasons for the step down to 25bps remain valid: whether the peak is 5% or 6%, it is relatively nearby and the confidence that we should have that rates have not risen enough should therefore be decreasing rapidly. Moreover, since monetary policy works with a lag and there has been very little lag since the aggressive tightening campaign began, it would be reasonable to slow down or stop to assess the effect that prior hikes have had.
But here is the bigger point, and one that Powell did not broach. There is really not much evidence at all that the Fed’s hikes to date have affected inflation. It is completely an article of faith that they surely will, but this is not the same as saying that they have. Consider for a moment: in what way could we plausibly argue that rate hikes so far have been responsible for the decline in inflation? The decline in inflation has been entirely from the goods sector, and a good portion of that has been from used cars returning to a normal level (meaning, in line with the growth in money) after having overshot. How exactly has monetary policy driven down the prices of goods?
This is not to say that higher interest rates have not affected economic activity, and this (to me) is the real surprise: given the amount of leverage extant in the corporate world, it amazes me that we haven’t seen a more-serious retrenchment. Some of this is pent-up demand that still needs to be satisfied, for example in housing where significant rate hikes would normally dampen housing demand substantially and seems to have. However, there is a severe shortage of housing in the country and so construction continues (and home prices, while they have fallen slightly, show no signs of the collapse that so many have forecast). Higher rates are also rippling through the commercial MBS market, as many commercial landlords have inexplicably financed their projects with floating rate debt and where the cost of leverage can make or break the project.
Higher interest rates, on the other hand, tend to support residential rents, at least until unemployment eventually rises appreciably. I think perhaps that not many economists are landlords, but higher costs tend to not result in a desire to charge lower rents. On the commercial side, leases are for longer and turnover is more costly, but the average residential landlord these days is not facing a shortage of demand.
So where have rate hikes caused inflation to decline? Judging from the fact that Median CPI just set a new high, I think the answer is pretty plain: they haven’t. And yet, the Fed believes that if they keep hiking, inflation will fall into place. Where else can we more plainly see at work the maxim that “if a piece doesn’t fit, you’re not using a big enough hammer?” Or maybe, this is just a reflection of the notion that if you want something bad enough, the wanting itself will cause the thing to happen. [N.B. this is really more in line with the prescription from Napoleon Hill’s classic book “Think and Grow Rich”, but the title of Peale’s equally-classic “The Power of Positive Thinking” suggested a catchier title for this article. Consider it poetic license.]
Moreover, what we have seen is that higher interest rates have had the predicted effect on money velocity. Although I have elsewhere noted that part of the rebound in money velocity so far is due to the ‘spring force’ effect, there is substantial evidence that one of the main drivers of money velocity is the interest rate earned on non-cash balances. Enough so, in fact, that I wrote about the connection in June 2022 in a piece entitled “The Coming Rise in Money Velocity,” before the recent surge in velocity began. [I’d also call your attention to a recently-published article by Samuel Reynard of the Swiss National Bank, “Central bank balance sheet, money, and inflation,” where he incorporates money velocity into his adjusted money supply growth figure. Reynard is one of the last monetarists extant in central banking circles.]
Now, nothing that I have just written is going to deter Powell & Co from continuing to hike rates until demand is finally crushed and, according to their faith but in the absence of evidence to date, inflation will decelerate back to where they want it. But with long-term inflation breakevens priced at levels mirroring that faith, it is worth questioning whether there is some value in being apostate.
Moving Goalposts
The equity melt-up continues, with the S&P 500 now up more than 25% year-to-date in a period of stagnant growth and an environment of declining market liquidity. The catalysts for the latest leg up were the comments and testimony by Fed Chairman-nominee Janet Yellen, whose confirmation hearings began today.
Her comments should alleviate any fear that Yellen will be anything other than the most dovish Fed Chairman in decades. Ordinarily, potential central bankers take advantage of confirmation hearings to burnish their monetarist and hawkish credentials, in much the same way that Presidential candidates always seem to try and campaign as moderates. It makes sense to do so, since the credibility of a central bank has long been considered to be related to its dedication to the philosophy that low and stable prices promote the best long-term growth/inflation tradeoff. Sadly, that no longer appears to be the case, and Janet Yellen should easily be confirmed despite some very scary remarks in both the scripted and the unscripted part of her hearing.
In her prepared remarks, Yellen commented that “A strong recovery will ultimately enable the Fed to reduce its monetary accommodation and reliance on unconventional policy tools such as asset purchases.” Given half a chance to repeat the tried-and-true mantra (which Greenspan used repeatedly) about the Fed balancing its growth and inflation responsibilities by focusing on inflation since growth in the long run is maximized then inflation is low and stable…Yellen focused on growth as not only the primary but virtually the only objective of the FOMC. As with Bernanke, the standard which has been set will be maintained: we now use extraordinary monetary tools until we not only get a recovery, but a strong recovery. My, have the goalposts moved quite a lot since Volcker!
That means that QE may indeed last forever, since QE may be one of the reasons that the recovery is not strong (notice that no country which has employed QE so far…or ever, as far as I know…has enjoyed a strong recovery). In a very direct sense, then, Yellen has declared that the beatings will continue until morale improves. And I always thought that was just a saying!
I would call that borderline insanity, but I am no longer sure it is borderline.
Among other points, Yellen noted that the Fed is intent on avoiding deflation. In this, they are likely to be successful just as I am likely to be successful in keeping alligators from roosting on my rooftop. So far, there is no sign of it happening, hooray! I must be doing something right!
Yellen also remarked that the Fed might still consider cutting the interest it pays on banks’ excess reserves, or IOER. The effect of this would be to release, all at once, some large but unknown quantity of sterile reserves into the transactional money supply. If there was any question that she is more dovish than Bernanke, there it is. It was never clear why the Fed was pursuing such a policy – flood the market with liquidity, and then pay the banks to not lend the money – unless the point was merely to reliquify the banks. It is as if the Fed shipped sealed crates of money to banks and then paid them rent for keeping the boxes in their safes, closed. If you’re going to do QE, this is at least a less-damaging way to do it although it raises the question of what you do when you need the boxes back. Yellen, on the other hand, is open to the idea of telling the banks that the Fed won’t pay them any longer to keep those boxes unopened, and instead will ship them crowbars. This only makes sense if you really do believe that money causes growth, but has nothing to do with inflation.
The future Fed Chairman also declared that the Fed has tools to avert emergence of asset bubble. Of course, no one really doubts that they have the tools; the question is whether they know how and when to use the tools. And, to bring this to current events, the question is no longer whether they can avert the emergence of an asset bubble, but whether they can deflate the one they have already re-inflated in stocks, and an emerging one in property! Oh, wait, she’s at the Federal Reserve…which means she won’t realize these are bubbles until after the bubble pops, and then will say that no one could have known.
Now, it may be that the U.S. is merely nominating Dr. Yellen in self-defense, to keep the dollar from becoming too strong or something. Last week’s surprise rate cut from the ECB, and the interesting interview by Peter Praet of the ECB in which he opens the door for asset purchases (which interview is ably summarized and dissected by Ambrose Evans-Pritchard here), keeps the heat on the Fed to remain the most accommodative of the major central banks.
At least the ECB had a reasonable argument that there was room for them to paint the least attractive house on the block. Europe is the only one of the four major economies (I exclude China since quality data is “iffy” at best) where central-tendency measures of inflation are declining (see chart, source Enduring Investments).
And that is, of course, not unrelated to the fact that the ECB is the only one of the four major central banks to be presiding over low and declining money supply gowth (see chart, source Enduring Investments).
Still, the Bundesbank holdovers must be apoplectic at these developments. I wonder if it’s too late to nominate one of them to be our next Fed Chairman?
There is of course little desire in the establishment to do so. The equity market continues to spiral higher, making the parties louder and longer. It is fun while it lasts, and changing to a bartender with a more-generous pour might extend the good times slightly longer.
It is no fun being the designated driver, but the good news is that I will be the one without the pounding headache tomorrow.
[Hmmm…erratum and thanks to JC for catching it. The S&P is “only” up 25.6% YTD (my Bloomberg terminal decided that it wants to default to the return in Canadian dollars). So originally the first paragraph had “32%” rather than 25%. Corrected!]
Transparently Dovish
Markets are finding it a little hard to believe that the Fed really said what it said. Stocks opened the day with a rally, along with commodities and bonds and especially TIPS. All of these markets leapt forward out of the gate, which is a completely understandable response. I was pretty clear in yesterday’s comment, but there were a couple of additional points that I either ignored or gave short shrift.
The first of these is that while I mentioned that Bernanke said “we’re not absolutists” about inflation, that really doesn’t capture the idea as clearly as he said it. Here is the full quote (and thanks BN for reminding me):
We are not absolutists. If there is a need to let inflation return a little bit more slowly to target to get a better result on unemployment then that is something that we would be willing to do.
It is hard to read that as anything except probably the single most-dovish thing that a Fed Chairman has said in eons. He explicitly states, essentially, that not only is employment as important as inflation in the FOMC’s consideration of its mandate, but that at this time inflation is actually subordinate to employment. This is essentially a vague form of the Evans Rule, which Chicago Fed President Evans proposed as a way to semi-formally declare that inflation doesn’t matter until (a) it’s out of control or (b) unemployment gets down to some certain level. Formally, it would read something like “the Fed will keep rates at zero and tolerate 3% (or 4%) annual inflation until unemployment is down to 7% (or 6%).” I wrote about this back in early November, never dreaming that it had a serious chance to become policy. It’s worse than policy now – it has a mushy informality that is guaranteed to make any ultimate decision to raise rates in restraint of inflation even more difficult. Back in November, I expressed my opinion of such a rule, and I must say I don’t disagree with this comment:
If they do take such a step, though, it is an unmitigated disaster for monetary policy and a sign to grab every real investment in sight. Because allowing 3% or 4% inflation has nothing to do with the Unemployment Rate, and moreover there is no sign that the Fed has anything like the kind of power they would need to lock the inflation rate at any particular level. Such a statement would mark a surrender against inflation in order to make a Quixotic charge on unemployment. If the world’s largest central bank goes that route, then bill-printers of the world unite! You have nothing to lose but your change.
It is inexcusable that I didn’t carry the “absolutist” quote to its full length and implication. But I also missed a small subtlety that is less egregious. The Fed, in stating formally that 2% inflation “is most consistent over the longer run with the Federal Reserve’s statutory mandate,” already nudged the goalposts a bit. For some time it has been tacitly understood and occasionally communicated explicitly in speeches that the Fed operated as if it had a target of 2%-2.25% on core CPI inflation. The Fed has long preferred the core PCE Deflator as a measure of inflation, and the PCE deflator has generally run around 25bps lower than core CPI over time, so the 2-2.25% CPI target was really a 1.75%-2.00% target on core PCE.[1] By saying that the Fed’s informal target was 2%, the Committee (a) nudged the target up slightly from 1.75%-2.00% to just 2.00%, and (b) made clear that inflation can go at least another 0.3% higher before it even gets to the target, and probably wouldn’t alarm them until it was at least 0.8% higher than the current level. That would be a core CPI inflation rate around 3.0%, well above the current level. No wonder they aren’t alarmed at the strong, steady advance in core CPI!
Investors seem to barely believe their ears. While commodities ended the day +0.4%, stocks slipped into the red. Still, the equity chart to me bears an uncanny resemblance to the chart in the months following Bernanke’s Jackson Hole speech in which he essentially announced QE2 (see Chart, source Bloomberg).
Narrow ranges, steady advancement, and all on top of markets that were not cheap to begin with. Today’s selloff of a mere -0.6% doesn’t alarm me and I think equities will continue to climb, although commodities offer much more inflation “beta” at this stage of the cycle and with negative real rates.
In my view, this action is no less clear a sign that the Fed is going to continue to pump liquidity into the markets than Bernanke’s speech was in the summer of 2010. It is much more remarkable, in that back then core CPI was preparing to print a low of 0.6% and now it is 2.2% and rising, but it is not much less clear. After all, that has become the Fed’s game: transparency, transparency, transparency.
For a very long time (as in, more than a decade) I have been railing about how Fed glasnost is a bad idea with no real upside. It has generally been pretty lonely to have that view, since “transparency” seems like a good thing and in many areas of government we could use lots more. But I was pleased today to get news of a speech from former Fed Governor Warsh in which he said the transparency has gone too far:
Central bank transparency is good, but transparency that delineates future policy breeds market complacency. It threatens to undermine the wisdom of the crowds and the essential interchange with financial markets.
Now, I’ve said similar things in the past about transparency and market complacency – overconfidence breeds over-leverage; if you want to cause deleveraging then the Fed should start doing unpredictable, random things like moving the Fed funds rate 17bps one day and then moving it back the next day, or only making moves in prime numbers, or scheduling an FOMC ‘tea’ instead of a board meeting. Act crazy and investors will keep a bigger margin of safety, which means they will use less leverage. But Warsh raises another very interesting and important point that I haven’t noticed before: if the Fed is too busy telling the market what to do, it can’t be listening to the market to learn what to do. When you think about it, aside from arrogance this conveys a mistrust of markets that is a hallmark of liberal institutions. Failed liberal institutions.
In economic data today, Durable Goods and Chicago Fed came in strong, while New Home Sales was soft but at continued low levels which makes them irrelevant in any event. Initial Claims was roughly on-target (but we’re still in the choppy year-end waters during which Initial Claims can be ignored). But all of this is back-seat stuff if the Fed is pressing pedal to the metal.
Friday introduces another weekend filled with searing promise for solutions in Europe; and the weekend precedes a Monday stuffed with bitter disappointment. It seems to happen every week, and I don’t see any reason it should differ this week.
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One quick note: in August 2010 I wrote an article called “The ‘Real Feel’ Inflation Rate,” in which I discussed a paper I’d written discussing how economists might go about assessing quantitatively how inflation feels as distinct from how it is precisely measured. I’m pleased to report that the paper has finally been published in this month’s Business Economics, the journal of the NABE. It’s only available to subscribers, unfortunately, but membership in the NABE is only $150 per year online. (I am not a member, so consider this a public service message). I should mention that I am looking for a corporate partner who would be interested in developing the methodology and perhaps commercializing such an index – contact me if you are interested or know of someone who is.
[1] There are several differences between PCE and CPI. One important one at the moment is that the PCE deflator has a higher weight in housing, so it’s currently at 1.70% on core, but there are other differences as well covering the functional form, the items that are included or excluded for each one, and the weights for those. There may be a very slight reason to prefer PCE as a technically ‘better’ index, but there is a large reason to prefer CPI and that is that there is an explicit market price for inflation expectations in CPI form: inflation swaps. There is no such market price for PCE. So I don’t think the Fed has made the right decision anyway.
