In his zeal to avoid signaling where interest rates are headed, Federal Reserve Chairman Kevin Warsh has obscured something else that’s crucial to investors, analysts and other policymakers: How he would react when challenged by the economy.
Warsh will appear before lawmakers Tuesday and Wednesday, and Fed watchers will be listening for clues to his thinking on inflation, the labor market and growth — and how those factors interact with interest rates. If his recent public performances are any guide, he’ll leave them wanting.
The chairman has vowed to eliminate what central bankers call forward guidance, or signals about the path for rates, and at his first press conference on June 17, Warsh dodged several questions. Asked, for example, how patient policymakers can be in waiting for inflation to come down, he responded: “Your question sounded like an encouragement for me to give forward guidance.”
Frustration is building outside the Fed, and one of Warsh’s most prominent colleagues has drawn attention to the issue. Governor Christopher Waller, in remarks last week in Rome, made a point of outlining the difference between offering forward guidance and explaining how the central bank might react under different economic conditions. The latter, he said, helps reduce uncertainty for markets and for households, “and that makes everybody’s lives better.”
“Reaction Function”
In addition to “forward guidance,” the phrase that keeps popping up is “reaction function,” which Waller and several other economists have used. It’s a wonky piece of jargon at the center of the discussion, and it’s crucial, economists say, to draw a line between the two concepts.
As Bloomberg Economics’ Andrew Sacher explained, “forward guidance tells markets what route the central bank thinks it will take. A reaction function tells markets how the central bank will navigate surprises without giving the expected route.”
Many, including Waller, have noted that Warsh has a legitimate argument when he says too much forward guidance can put policymakers in a bind by creating the impression they have committed to future interest-rate decisions. But in failing to reveal his reaction function, he may also be posing a serious risk.
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Pricing in financial markets, especially key benchmarks like the 10-year Treasury note or the Secured Overnight Financing Rate, are based in part on how investors believe the central bank will behave over time. If that understanding is sharp, market participants can plug in their own forecast for the economy and make a reasonable prediction of where rates might go. That, in turn, can help avoid volatility if the forecast proves roughly correct, and even shorten the time it takes for rate changes to influence the economy.
“Good communication conveys the Fed’s reaction function, which is the relationship between economic conditions and the path of the policy rate. And really that’s what’s essential,” said Richard Berner, professor at New York University who served on the Fed’s research staff in the 1970s. “That’s different from forward guidance.”
A Fed spokesperson declined to comment.
Ceding Leadership
Warsh pushed back at the notion he’s not providing enough clarity by pointing to the bond market when he appeared on a panel with other central bankers in Portugal on July 1.
“Volatility is not up, it’s down,” he said. “So I hear this, as if people don’t understand. I think they actually understand quite well.”
Not everyone is convinced. Michael Feroli, chief US economist at JPMorgan Chase & Co., said if Warsh continues holding back, he risks ceding leadership of the Fed’s communications to other policymakers.
“He’s yet to demonstrate any command of what’s currently going on in the economy,” Feroli said. “We’re just going to have to turn to other Fed officials to get an understanding of their read of the economy.”
Warsh’s strategy has applied not only to his public comments. He also declined to participate in June when policymakers submitted their quarterly economic forecasts and rate projections, which is used to generate the so-called dot-plot. The statement issued after the meeting was notably shorter, and minutes of the gathering issued three weeks later were also somewhat shorter.
Those same minutes to June’s rate meeting showed Warsh had support in shortening the post-meeting statement, and some participants welcomed a review of their communication practices. Other officials have also recently talked about the need to scale back on forward guidance to investors in light of heightened economic uncertainty.
But that support could erode if the strategy obscures the Fed’s framework for understanding and reacting to economic conditions. In Rome, Waller said the need for clarity in the reaction function has been “one of the critical things” learned over the last three decades of central banking.
Past Mess
Lou Crandall, chief economist at Wrightson ICAP LLC., started his career in the 1980s, and remembers when the Fed didn’t even communicate its interest rate decisions. “That was just an absurd mess,” he said.
Then-Chairman Alan Greenspan — whom Warsh invoked during his swearing in ceremony — incrementally expanded his communication with markets. Still, he remained vague enough that investors based bets on the most obscure of hints — like the size of Greenspan’s briefcase heading into policy meetings.
“There are lots of folks in the markets who go on a tear with their own particular view of how the Fed is thinking about things. And those kinds of theories proliferate when the Fed is not trying to outline its own views — not with certainty, but with some clarity,” Crandall said.
Don Kohn, a former Fed vice chairman, said it’s fine for a new chairman to take his time to clarify his own thinking, but he thinks Warsh will eventually open up.
“At some point he’s going to have to give a more detailed economic perspective, give us his perspective and how that meshes with the committee,” said Kohn. “I assume this is not gonna last forever.”
