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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.
Multiple Poppycock Warning on Warsh Fed Meeting #1
People are worried about rising interest rates at the long end of the curve. “The Fed should raise interest rates,” they say, “to bring interest rates down.”
Just a quick rationality check there: read the sentence a couple of times.
I know you’ve been told that long interest rates go down when the Fed has ‘credibility,’ and they can only have credibility if they raise rates. That’s double-poppycock. First, because when the Fed raises interest rates, interest rates go up even at the long end of the curve. Don’t believe me? Here’s the 30-year bond yield, plotted against the Fed funds rate. I want you to find for me the place where the Fed tightened and yields fell. Go ahead, I’ll wait.
Now, I’m not saying that yields never go down when the Fed is hiking, or vice versa. It’s just very rare. And yields move around for lots of reasons, so sometimes Fed funds and long yields move in the opposite direction for spurious reasons. But it is super clear that the main driver of long interest rates is short interest rates.
I said it’s double-poppycock. The second way is because the notion that the Fed (or new Fed Chairman Warsh) will only have credibility if it raises rates is actually an embedded double-poppycock. First, because the Fed doesn’t have any credibility and hasn’t for years…unless you meant in the macro (but important) sense that people believe the Fed will ride to the rescue during a calamity. They don’t have any credibility as inflation fighters, because (a) until recently they hadn’t had to fight inflation for 35 years, so there was little opportunity to build inflation-fighting credibility and (b) the one time they did, they screwed it up so bad that they’re still fighting the inflation they created, five years later. The second of the embedded double-poppycocks is that raising rates is just the wrong thing to do, because raising rates without reducing money growth causes velocity to rise and inflation to accelerate.
Warsh has been pretty clear that to fight inflation, the Fed needs to shrink the balance sheet and slow money growth, and they can do that while lowering interest rates. I have no idea why people think that means he wants to raise interest rates, or needs to. But these are the same people who are seeing headline inflation jump because of rising gasoline prices and then tell you it makes it more likely the Fed is going to tighten.
Poppycock. Actually, double-poppycock. First, because rising gasoline prices affect mainly headline inflation and the Fed doesn’t even focus on headline inflation; second, because rising energy prices tend to slow growth, and historically the Fed has erred when they didn’t ease into a growth shock.
Now, having said all of that…there are currently some bad signs for inflation that the Fed should address by shrinking the balance sheet as quickly as they can. It was disheartening to head Chairman Warsh utter the poppycock (just one) about the system needing ‘ample reserves.’ The system did just fine for generations when the Fed had an extremely skinny balance sheet. The bigger problem now is that interest rates have risen enough that even if the Fed sold all of the bonds in the portfolio, it couldn’t drain nearly as much as they added by buying those bonds back when they were goosing things in 2020.
But here is the thing that I don’t hear people talking about, at least in the context of inflation and monetary policy:
The economy is just not slowing down very much…maybe it is just beginning to?…despite tighter financial conditions from higher interest rates and a supply shock from higher energy prices. Yeah, the 30y bond is at 5.2%. Where is that having an impact on growth? Higher rates mean less cash-out refinancing to help sustain consumption, a greater propensity to save (which is after all why market interest rates rise, to induce savings because other sources of dollars aren’t keeping up with the demand for dollars), and a stronger dollar which weakens foreign demand for our goods. Higher energy prices are, to be sure, a zero-sum game financially when we are mostly self-sufficient in energy, but historically higher energy prices have slowed ex-energy growth.
The fact that this isn’t happening, and that equities are not appreciably declining despite higher interest rates, is concerning because it suggests – to me at least – that there is too much liquidity in the system. M2 is rising at 5.5% y/y, and that’s too fast in the current environment (as I’ve pointed out before). It’s rising at a 7.2% annualized rate over the last 6 months.
And that’s happening partly because the Fed has been growing the balance sheet, not shrinking it.
It doesn’t feel like that is enough to explain the bulletproof economy, so it may be that there’s shadow liquidity from (for example) the growth of stablecoins. Now, economic growth is not a bad thing in itself, and growth doesn’t cause inflation. But if the amount of money growth is accelerating, and the benefit from holding non-cash balances is increasing (tending to raise velocity), and that’s enough to keep the economy pushing right through an energy shock and the higher cost of money…then to me that says it’s going to be hard to keep it from leaking into prices. The Fed does not need to hike rates – that would only make things worse. The Fed needs to take stern action on the balance sheet, though, and soon.
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?!
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.
