Federal Reserve Chair Kevin Warsh is changing how the central bank conducts monetary policy. A fresh look is appropriate, especially given the Fed’s failure to achieve its 2% inflation objective for more than five years. But this needs to be done with greater care than Warsh has shown to date.
In particular, deliberately obscuring the Fed’s monetary policy reaction function — how the Fed would likely adjust interest rates in response to changing economic circumstances — threatens to undermine its effectiveness and make it harder for the Federal Open Market Committee to achieve its stated goal of price stability.
On the positive side of the ledger, streamlining the FOMC policy statement is appropriate. The statement had become long and cumbersome, in part because of the intense scrutiny paid to any adjustments.
The Fed had been caught in a bad feedback loop: The risk that the market might overreact to changes in the statement caused Fed officials to be more reluctant to make changes, which increased the market’s sensitivity to any changes. Warsh used his first FOMC meeting to revise and shorten the statement, helping to address this problem.
That said, the statement conundrum won’t go away. Fed officials will face the same issue at future FOMC meetings — how to change the statement to keep it up to date without provoking an overreaction. The result could be a very short, not very informative statement.
In the same vein, eliminating forward guidance about what the Fed expects to do next is also warranted. By focusing attention on the baseline forecast, forward guidance can unnecessarily inhibit policymakers from pivoting rapidly should economic circumstances deviate markedly from their expectations. A strong case for forward guidance only exists when short-term rates are at the zero lower bound. When this tool is no longer available, forward guidance can be used to alter expectations in a way that lowers long-term rates and eases financial market conditions further.
Setting up five task forces on communications, balance sheet policy, data, productivity and jobs, and inflation frameworks may also prove useful. The devil here lies in the details — what’s the remit and who are the decision-makers? Will the analysis be even-handed and unbiased or skewed to justify the chairman’s already stated views or ideological positions?
Where Warsh goes much too far, however, is in refusing to discuss his or the FOMC’s monetary policy reaction function.
He was asked repeatedly during his first press conference about what he would have to see to adjust policy. He refused to answer and said instead that it should be left to financial markets to figure it out: “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.”
Leaving it to financial markets has two major problems. First, it makes policy much less determinant, because financial markets don’t price to what the Fed should do, but to what they think it will do.
If the Fed doesn’t reveal information about its reaction function, how will markets correctly assess its likely response to incoming information? Or put another way, if the Fed is looking to the markets for guidance and markets are looking to the Fed for guidance, what’s the mechanism for setting monetary policy?
Second, this change will slow down the transmission of monetary policy to the real economy and make it less efficient. Monetary policy in the US works mainly through its impact on financial conditions including long-term rates, stock prices, credit spreads and the exchange value of the dollar. Short-term rates don’t have a strong independent effect on economic activity.
In this regime, if financial markets better understand the Fed’s monetary policy reaction function, they can more quickly and accurately incorporate new information into prices — speeding and tightening the relationship between the path of short-term rates, financial conditions and the real economy.
In contrast, if the Fed’s reaction function is deliberately obscured, then financial conditions will be less accurately priced to what the Fed will do, undercutting the efficacy of monetary policy to achieve the Fed’s twin goals of price stability and full employment.
The movement toward greater transparency over the past 32 years — begun by Alan Greenspan with a short FOMC statement when policy was changed in February 1994 and extended by Ben Bernanke, Janet Yellen and Jerome Powell — recognizes the importance of financial market participants understanding the Fed’s response to an evolving economy.
Providing information about this is much different than forward guidance. Forward guidance is disclosure about what the Fed expects to do; the reaction function tells us how the Fed would respond to a changing array of economic circumstances.
Warsh could enhance the market’s understanding of the Fed in two ways. First, the forecasts for economic growth, inflation and employment submitted by FOMC participants could be linked explicitly to their short-term rate projections. This would enable one to discern whether differences in their rate projections stem from differences in economic forecasts or in monetary policy reaction functions.
Second, the Fed could publish a baseline staff forecast with alternative scenarios. These would provide information about how the FOMC might respond should the economy deviate meaningfully from its baseline forecast, enhancing understanding about the FOMC’s reaction function.
It’s important not to throw the baby (information about the Fed’s reaction function) out with the bathwater (forward guidance). Warsh has not yet clearly distinguished between the two and has deliberately obscured the Fed’s monetary policy reaction function. If this is not rectified, the result will be more uncertainty, greater rate volatility and a less timely and efficient transmission of monetary policy to the real economy. It’s the Fed’s job to set monetary policy, not financial markets.
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