The US Federal Reserve will soon have a new chair of its board of governors, Kevin Warsh. He will have to contend with the outgoing Jerome Powell continuing to participate in the 12 member meetings of the Federal open market committee (FOMC), which sets short-term interest rates.
Warsh remarked in his Senate hearings that he would prefer more debate and dissonance on the committee, which has been remarkably absent in recent years ― “messier meetings without pre-rehearsed scripts”. No doubt he will get more of it if he is prepared to listen.
There is enormous attention paid and constant pressure from politicians for lower rates in the US. Borrowers clearly have more political heft than lenders. Yet why short-term interest rates as set by the Fed matter as much as they do in the US is something of a mystery given that much borrowing and lending, including mortgage lending, is undertaken over extended periods at predetermined fixed rates.
Warsh also indicated that he did not approve of the FOMC members sharing their views about the future direction of interest rates over which the committee exercises control. The argument for doing so is presumably to better inform the market about the direction of interest rates, so the Fed would be less likely to disturb the forward-looking actions taken by market makers.
Surely monetary policy should act predictably, not to surprise the market, which will always be doing as well as it knows how to anticipate Fed action. If its expectations are well-informed, this will allow for better planning and debt management and less risk.
Less uncertainty about interest rates and less risk priced into the marketplace are surely the objectives of monetary policy. Economic policy can logically only help fine-tune the economy and moderate the business cycle by acting in advance of the market based on a presumed superior ability to forecast the state of the economy.
The economic forecasts of market participants are likely to be as good as those of the central bankers, whose actions will be anticipated and reflected in forward-looking forecasts of interest rates and financial markets generally. A market waiting for the Fed to act does not describe reality. A market that anticipates Fed action to avoid losses or make profits describes the forces at work.
Ordinarily data dependence for the Fed and its watchers, as opposed to forecast dependence, will serve the economy well enough. If spending is running observably too hot ― driving up prices ― the case for raising short-term rates to cool things down is obvious enough and predictable.
And vice versa should the data indicate that the economy could grow faster and more spending, encouraged by lower borrowing costs, is called for and will also be easily predicted.
Problems arise when prices are rising for supply side reasons, because less is being supplied, for example when energy prices or food prices are shocked higher, leading to higher prices generally. Such temporary shocks do not call for higher interest rates.
Higher prices act to restrain spending, as do shocks. The best central banks can do in the case of a shock is very little and be expected to do so. But the central bank may believe, as the European Central Bank and South African Reserve Bank presently assert, that a temporary shock to prices may lead to more inflation expected over the long term and hence permanently higher inflation ― regardless of the state of demand.
My view is that prices do not simply do what they are expected to do ― they depend also on what the market will bear. A stagnant economy ― too little demand ― must restrain the prices that are set regardless of extrapolated expectations.
The playbook for dealing with supply side shocks is by no means agreed, either by central banks or their watchers. This adds to the difficulty of predicting policy reactions, adding to market risk.
In his testimony Warsh was critical of the Fed’s reaction to Covid when it believed (wrongly) that the shock to prices in 2020 was temporary and did not raise interest rates accordingly. “The Fed missed its mark,” he said, and the “fatal policy error” of 2021 and 2022 “is still a legacy we’re dealing with”.
What he said is needed now is “a regime change in the conduct of policy”, including “a new inflation framework, new tools and a new approach to communicating its messages”.
The Fed missed because it allowed a short-term supply side (Covid) shock to supply to be accompanied by an extraordinary increase in the money supply caused by large direct transfers from the federal government to the bank deposits of households and firms, stimulating demand and raising inflation.
Central bankers should know better than to ignore money supply and financial conditions generally when assessing the state of an economy.
Warsh has more uncomfortable legacies to deal with than a failure to model inflation. He has a balance sheet to manage with a huge load of federal debt (about 12% of all federal debt) and a US Treasury now spending at almost Covid levels while adding to federal debt (now about 120% of GDP) at about a $2-trillion annual rate.
Keeping the Federal Reserve in a narrow monetary policy lane, as he intends, will test all the acumen and political savvy of the new chair.
• Kantor is head of the research institute at Investec Wealth & Investment. He writes in his personal capacity.
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