Fed Policy – Kevin Warsh is right; stop giving macro projections

There is a popular piece of satire that if all the economists in the world were made to stand in a single line, they would still not reach a conclusion. The reference here is more about economics being a science of possibilities than about outcomes.

What the June Fed policy said?

The Fed policy statement announced this week held rates at 3.50%-3.75%. However, there were subtle indications that rate cuts were done for now. Also, the signal was that rates could be hiked up to 50 basis points over next 1 year if inflation went out of hand. The most important point in the policy statement by Kevin Warsh was a reference to the need and purpose of giving medium to longer term macro projections. He underlined that the Fed should reduce its focus on giving regular updates on financial projections. Instead, the focus should be on data response and a fine-tuned strategy.

Being consistently wrong about the future

That is where our original sentence about the satire on economists comes into play. If you look at the Fed projections over the last 3 years, most of the projections have been very consistently wrong. It is not about the economists, but about the way the macros have evolved. Events like the pandemic, subsequent supply chain constraints, Russia-Ukraine war, Western response, the Iran-US war, and the blockade of the Straits of Hormuz were shock events. Each of these events forced the Fed to rapidly change its projections and also its outlook. For example, the entire thrust of the Fed has now shifted from when to cut rates to when to hike rates. In less than 2 months, view has turned hawkish.

Getting your financial projections wrong

The US Fed offers macro projections of GDP, interest rates, core inflation, headline PCE Inflation, and unemployment over the next 3-4 years. While interest rate is the output, the rest are inputs. For example, economists expected a sharp negative impact of the tariffs and the US-Iran war on GDP, but it never happened. Same was the case with unemployment, which has trended towards 4.2%, despite fears that it could spike amid all the macro disruptions. Most projections on inflation have been way off the mark. Economists were betting on inflation returning to 2% by 2026, but now that looks very far-fetched. Clearly, longer term projections are not adding too much value.

Why the Kevin Warsh shift is critical?

Warsh has referred to the market probabilities influencing projections, rather than the other way round. That is true. Quite often, we have seen the quarterly macro updates being overly influenced by the CME Fedwatch, which is more of a futures-based risk pricing. That is getting the causality wrong. One of the big changes Kevin Warsh wants to introduce is to make the policy more analytical and response-oriented, rather than offering guidance. He wants to channel the Fed energies and focus on what really matters as a regulator. That is one of the big changes that Kevin Warsh plans to introduce at the Fed, and that could be interesting and also have long-term positive ramifications.