Kevin Warsh Dilemma – To act or not to act on interest rates?

Fed chair, Kevin Warsh, did not hike rates in the 29-July FOMC meet. The vote was just about 9:3, with more members slowly gravitating to the hawkish side. For the US consumer, high inflation is bad, and Fed doing nothing is still worse!

Accepting the limited power of projection

In a sense, what Kevin Warsh is doing is that he is making a statement most of us knew all along. US interest rate is the price of money and has a direct impact on the dollar. By default, prices are erratic, so giving any guidance is more ambitious than enlightening. If you look at the last 20 years, most projections of macros by the Fed have been off tangent. Macros, these days, are too complicated to be predicted using any scientific models. Hence, according to Kevin Warsh, it makes a lot more sense to have an action plan and react to macros than try and predict macros and act on these projections.

Kevin Warsh is also walking his talk

If one looks at the Fed statement and the discussions by Kevin Warsh with the press, he has been sticking to his mandate of giving very limited macro guidance. For instance, the Fed statement has been substantially shortened just explaining the decision and avoiding any macro projections on interest rates, GDP, inflation, or unemployment. Secondly, when the quarterly projection of macros were presented in June this year, other members of FOMC did offer their projections on inflation, jobs, and GDP growth, but Kevin Warsh avoided any projections himself. Even in his speeches, he has emphasized that inflation control remains his priority, but has refused to be drawn into projections.

Who should be leading; markets or the Fed?

This virtual refusal by Kevin Warsh to be drawn into macro projections has brought back the old debate. Should the Fed lead the markets, or should it be led? That is the million-dollar question. In the aftermath of the Policy statement on 29-July, the 30-year bond yields touched a high of 5.23%. These were the levels of bond yields last seen ahead of the global financial crisis (GFC) in 2007. Bond markets do not react based on what they think the Fed should do, but based on what they think the Fed will actually do. Markets expect the Fed to be behind the curve. But the real big challenge for Kevin Warsh from this approach will be when it comes to managing inflation expectations.

Deftly managing inflation expectations

Over the years, the Federal Reserve has set an example of a central bank that is not only transparent about its expectations of the macros, but also acts accordingly on monetary policy. This made the Fed a lot more predictable. Over a period, the investors, traders, fund managers, and even consumers started to look at the Fed as a serious manager of inflation and price stability. Thus, inflation expectations were anchored to Fed macro guidance. The question now is; if the Fed stops giving guidance, what will the market anchor its inflation expectations to? That is a question to which even Kevin Warsh does not have an answer; but he has to figure out a cogent response!