Warsh has deeper problems than a rocky start at the Fed

New Federal Reserve Chair Kevin Warsh has gotten off to a rocky start. The main problem is an unwillingness to share his thoughts about how he would adjust monetary policy to changes in the economic outlook. Getting rid of forward guidance is desirable, but outsourcing monetary policy to financial markets is not a viable strategy. If the central bank is looking to the markets for guidance and the markets are looking to the central bank for guidance, policy expectations become indeterminate and that just leads to greater uncertainty, confusion, higher risk premia, and a loss of Fed credibility.   

But Warsh’s problems go deeper. He has undermined his credibility by how he has talked about the Fed’s inflation objective. At his late July news conference, Warsh implied that the personal consumption expenditures index (PCE) could be jettisoned as the Fed’s primary inflation metric as soon as January.  "Who knows, come after next January, what we might say about strategy," he said. "I suspect that the task forces might have something to add."

Warsh went on to cite the Lucas critique and Goodhart’s law as reasons why a given inflation measure might become less useful once it has become enshrined as the Fed’s objective. While I don’t really understand this point, I do know that suggesting there was a possibility that the Fed would move the goalposts before reaching its 2% PCE objective isn’t a good way of reinforcing the commitment to price stability.

Moreover, Warsh hasn’t helped his cause by not explaining the key drivers of inflation or how monetary policy affects inflation outcomes. For example, is the underlying inflation trend (abstracting from short-lived demand and supply shocks) a consequence of a shortfall of the supply of workers relative to demand? Or is it a monetary phenomenon tied to the size of the Fed’s balance sheet, money supply growth and the amount of liquidity in the financial system?   

Warsh seems skeptical of the traditional Phillips Curve framework in which an overly tight labor market leads to higher rates of inflation, noting that price stability and a high level of employment aren’t necessarily incompatible. Although he acknowledges the importance of inflation expectations, he hasn’t explained what drives them and the role the Fed’s actions play in affecting those expectations. What we seem to be left with is that inflation depends on inflation expectations, which, in turn, depends on the Fed’s credibility to act to keep inflation in check. A framework that doesn’t include aggregate demand and supply is not credible. 

Warsh apparently puts some weight on the size of the Fed’s balance sheet and the growth rate of the broad monetary aggregates. It is noteworthy that the most recent Monetary Policy Report to Congress from the Fed includes a paragraph that highlights the growth rate of the broad money supply aggregate, M2, even as it also notes that "it is difficult to measure the stock of money in the modern economy." Meanwhile, Warsh has held out the prospect that shrinking the Fed’s balance sheet could exert sufficient restraint to enable the central bank to lower short-term interest rates.

Unfortunately, this just further muddies the waters. In the current monetary policy regime in which the growth of credit and the monetary aggregates are determined by the Fed’s short-term rate target, the relationship between monetary growth and economic activity is even weaker than it has been in the past.

Moreover, in the current regime of ample reserves, the growth rate of the broad money supply is more of a consequence of what’s happening to credit demand and economic growth, rather than a determinant of credit and economic growth. As long as the Fed sticks with its ample reserve regime, which seems likely, a smaller balance sheet is not likely to exert meaningful restraint on economic activity. 

Until Warsh clarifies his thinking, the Fed’s credibility will be at risk. That will increase the risk of inflation expectations becoming less well-anchored, making the Fed’s job to achieve price stability more difficult.   

This column reflects the personal views of the author and does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners. Bill Dudley is a Bloomberg Opinion columnist. A former president of the Federal Reserve Bank of New York, he is a member of Coinbase Global’s advisory council.