Most economists agree that frequent, clear communication and greater transparency are good things for central bankers. This should make policymakers more accountable, while also helping investors better understand the central bank’s "reaction function" — how it intends to achieve its goals. Most importantly, it can help anchor inflation expectations.
This is critical for keeping inflation under control because it can prevent wage-price spirals, in which the expectation of higher prices leads workers to demand higher wages, ultimately leading to faster inflation and the need for even higher wages. Clear communication can also help consumers, businesses and markets understand how the central bank might react to unforeseen developments, reducing uncertainty about the future path of interest rates.
But others, like Warsh, argue this is part of the problem. Too much communication can create confusing noise. Excessive transparency risks being interpreted as predictability, breeding complacency and, in extreme cases, moral hazard, where investors make reckless bets knowing that central banks will ultimately come to their rescue.
And what if the signaling, or "forward guidance," is simply wrong? Inflation has been above the Fed's 2% target for more than 5-1/2 years. The Fed has said many times that it intends to get back to target, but the last time it raised rates was more than three years ago. The fed funds rate has actually been cut by 175 basis points since then. When the gap between rhetoric and reality grows, how effective is all that talking?
In that light, you can see why Warsh wants a revamp.
But he needs to tread carefully. U.S. bond yields, especially long-dated and "real" inflation-adjusted yields, are historically high, and inflation is uncomfortably sticky. The term premium — the extra compensation investors demand for buying longer-term bonds instead of rolling over shorter-term debt — is flirting with its highest level in 12 years. This can be seen as a measure of perceived risk around inflation, the economy, financial stability or policy errors.
Warsh hasn’t helped himself thus far. His second press conference after the July Fed meeting has been widely panned, as it left investors scratching their heads about what his word salad of business-speak actually meant. Most worryingly, he seemed to suggest that the Fed might not be clear about its inflation target.
The problem, though, is that scaling back signaling, messaging, and communications overall, however well-intentioned, risks creating a void. Rightly or wrongly, uncertainty and market volatility are likely to fill at least part of that space. Households, businesses, and investors may have grown too accustomed to policymakers' guidance, but isn't that better than flying blind?
“I think we’re at a dangerous inflection point,” says Willem Buiter, an economist and former Bank of England policymaker. “Accountability is a key thing. Reducing the predictions offered by monetary policymakers collectively and individually would enhance market uncertainty and would make for worse economic outcomes.”
In the four decades preceding the COVID-19 pandemic, inflation and market-based interest rates were mostly trending down, as part of the so-called "Great Moderation." However, there were a few notable peaks amid that downward drift: when billionaire financier George Soros "broke" the Bank of England in 1992, following the September 11, 2001 terrorist attacks, and in the immediate aftermath of the GFC.
There is nothing today remotely resembling these crises, but uncertainty around the Fed – its independence, credibility, and increasingly, communications – is rising to levels not seen in decades – and so are borrowing costs.
If the Fed truly wants to bring inflation to heel, it will likely have to raise rates. But just as importantly, Warsh will need to be able to communicate his willingness to do so and the framework for it. If he can’t do this effectively, risk premia are likely to remain elevated.
"Amid such unease, silence from the Fed is deafening," says Jason Thomas, head of global research and investment strategy at Carlyle.
Whether Warsh likes it or not, markets need a message. In today’s environment, a failure to communicate is simply not an option.
TLT•
