Kevin Warsh on Wednesday put his stamp on his first FOMC meeting by keeping his promise to cut back forward guidance from the Federal Reserve’s communications. The post meeting statement has fewer words; the press conference is shorter; Warsh didn’t submit his projections for the dot plot; and he refused to answer any question that required him to sound like he was offering forward guidance.
As we have previously discussed, there can be a paradox of anti-forward guidance strategy. One simple example is that, when the market holds a strong view on certain future policy direction and the central banks don’t comment on it, the market will think the bank is implicitly agreeing with the view. It can still be a form of guidance to future monetary policy.
Well, Warsh doesn’t seem to hate this kind of interaction. He actually prefers it.
The more that markets are paying attention to what’s happening in the real economy — deciding what’s good data and what’s less good data — the more financial markets can price what they believe is the most likely and what are the tail risks. Financial market prices are probably the most important source of information to guide central bankers. But when all the financial markets are doing is reflecting back what we’ve said, then we’re taking the most important source of information and we’re being blind to it. I’d like us to create a system where those blinders come off.
Warsh is going further, though. He is not only refusing to give forward guidance — he is also signalling that whatever you do read from one meeting may have a six-week expiry date.
I can’t give any forward guidance about what we’re going to do next. The good news is we’ll be meeting in six weeks.
My worry is that this introduces an extra layer of unpredictability to Fed signal-reading—what he says about monetary policy this meeting may not carry any relevance for the next.
An Unstable Reaction Function
Which is also why commentators complain that Warsh is not only taking “interest rate policy pre-commitment” off the table, he is also blurring the Fed’s reaction function. Or, I would say that he is attempting to introduce an unstable reaction function into the Fed’s monetary policy decision making.
A stable reaction function is like a set of tools sitting in the cabinet: we know with confidence that in situation A we can use tool X; in situation B, tool Y is our answer. This kind of reaction function is not a pre-commitment. It is just an explanation of the central bank’s weapon sets to provide transparency and accountability.
It is ok to have different judgement of the economic conditions every six weeks. Economic data gets updated and economic environment changes. This is why the previous Fed regimes emphasized data-dependence— when the economy progresses, the reaction changes but the reaction function remains relatively stable. Policy changes are the results of changing economic understanding or interpretations; data leads to policy changes in a predictable manner.
If I take what Warsh claims by face value, the way policy will change is now a bit more “unpredictable.” He doesn’t want to commit out loud to any reaction function. When the “if” changes, he is not promising the “then” will always be the same; instead, it will be decided every six weeks.
This may no longer be data dependence. What is the Fed’s reaction function and is it always the same? Sorry, Warsh doesn’t want to tell us anything about it. You will not know for sure when the Fed will use which tool as Warsh doesn’t want you to know, this is between him, the FOMC and the Task Forces.
This reminds me of how the Trump administration does “deals.” Nothing is promised in a negotiation and they aim to confuse the counterparties and outsiders with “unpredictable” actions and reactions. But that is a negotiation setting, an assumed “zero-sum” situation and unpredictability may sometimes help improve their hands.
But in monetary policy making, who are the Fed chair “negotiating” with? The market? Other Fed officials? The public? The President? I am not really sure how to interpret this. But if the goal is to insert more uncertainty into monetary policy making, a potential consequence can be a more volatile financial market.
I am not sure if this is the outcome Warsh is expecting or prefers.
… reposted this!