Warsh’s allergy to these practices rests on nostalgia for what might be called the “classical” view of monetary policymaking. On this view, profit-seeking investors position their portfolios based on their assessment of underlying economic fundamentals. By conditioning their decisions on the resulting asset prices, policymakers can thus leverage the power of markets to synthesise disparate private information as they seek to target inflation.
If central bankers offer explicit guidance regarding their own future decisions, the critique goes, they introduce a disastrous feedback loop. Rather than wasting time on assessing economic fundamentals, investors will now take the shortcut of simply pricing the central bank’s pre-announced path. The flow of information becomes circular and loses its link to underlying economic reality. “When all financial markets are doing is reflecting back at us what we've said,” Warsh explained in June, “then we're taking the most important source of information and we're being blind to it.”
Warsh’s take has recent, painful evidence to back it up. When the Covid pandemic struck in early 2020, the Fed swiftly cut its main policy rate to between 0% and 0.25%. In September of that year, the central bank issued explicit guidance that it would not hike rates again until labour market conditions were consistent with full employment and inflation had topped its 2% target for some time. As a result, when core inflation – excluding food and energy costs - began to rise rapidly in early 2021, market expectations of future policy rates as measured by the yield on 2-year U.S. Treasury bonds remained rooted to the floor.
Only when the FOMC blinked and retired its characterisation of inflation as “transitory” in December 2021 did investors begin to price in the reality of an overheating economy. By that time, core inflation was heading above 5.5%. The FOMC itself, meanwhile, had interpreted the sanguine market for sovereign debt as independent confirmation that inflation would indeed quickly peter out. Its own lift-off was therefore even more delayed. Each side had assumed the other was monitoring the economic fundamentals. As it turned out, they had both just been ogling each other.
By ditching forward guidance, Warsh hopes to break this self-referential loop and force markets to price underlying risks again. That, he argues, will restore the informational value of asset prices and thus hand policymakers back their compass.
TLT•
