Chairman Kevin Warsh likes to measure his tenure as Federal Reserve Chairman in days, but after 127 days, promises of a change of government are taking shape. He is working quickly on a few simple, visible items that are within his direct control, but he is constrained by economic conditions and his Fed colleagues from making larger changes.
Mr. Warsh was quick to approve of the Fed’s communication methods. Some of the changes appear to be superficial, such as shortening press conferences after the Federal Open Market Committee meeting, which decides the Fed’s interest rate settings, and changing the alphabetical seating arrangement of reporters at different news organizations. However, these superficial changes hide deeper changes. Mr. Warsh’s thinking on monetary policy and the way he communicates his views represent a significant change from his predecessor.
Mr. Warsh has yet to act on reducing the Fed’s balance sheet, one of his key priorities, in part because inflation is a more pressing concern. And he kept other priorities to himself by appointing five task forces to investigate the Fed’s practices. They are due to report early next year.
Last week’s unanimous quarter-point rate hike and subsequent hikes are likely to be the highlight of Mr. Warsh’s early tenure, a move that responds to critics’ concerns about his independence from President Donald Trump. Given how Warsh has described his thinking about markets and the economy, it seems likely that he will support further rate hikes if inflation remains a problem. Last week’s increase was the first since 2023.
For a Fed chairman who prides himself on taking signals from the market, Wall Street is sending a strong signal. of 2 year government bond yield It was trading nearly a full point above the effective federal funds rate on Wednesday, a sign that traders expect further rate hikes. This is the largest spread between the two-year rate and the fund rate since 2023. Inflation is running at 3.7% as measured by the Fed’s Recommended Personal Consumption Expenditure Index for July, the most recent reading. It has exceeded the central bank’s 2% target for more than five and a half years.
Fed chairmen have long described the funds rate as either accommodative, neutral or restrictive. But when Warsh was asked about the Fed’s relative neutrality at a Sept. 16 press conference, he rejected that very premise. He responded that the concept was “academically useful” but not relevant to decisions to raise interest rates.
The comment caused a shock among some in central banking circles who are used to thinking about funds rates in such terms.
Economist Claudia Sahm said: “What’s strange is that Mr. Warsh touted this decision as “removing a certain amount of easing,” and then distanced himself from the concept that defines easing.”But now that the Fed has raised rates, how does it decide whether to start raising rates again, and when to stop?”
Following his mixed performance in July, Mr. Warsh’s critics argued that he lacked credibility because he had not articulated a consistent theory on how to set interest rates. But a close look at Warsh’s public comments suggests that a new system for making policy is slowly becoming clearer.
This regime includes a wide range of financial and market indicators. Warsh emphasized “fiscal health” as key to his thinking three times in a speech in Jackson Hole, Wyoming, and three more times in recent press conferences. He said that after reviewing the market situation, he found that the situation was not restrictive.
In Jackson Hole, he pointed to “the level and change in asset prices across sectors…the prices and trading volumes of Treasury securities…the foreign exchange value of the dollar…the cost and availability of credit…and the prices of a wide range of commodities.” Mr. Warsh continued: “These and other indicators should inform the Fed’s near-term outlook for economic activity and inflation across the business cycle. They should also clarify the state of broader financial conditions and the risks and uncertainties in the financial cycle.”
To some, this logic may feel circular, since expectations for the Fed are a big part of the financial picture. Feedback could therefore tell the Fed what the market expects from the central bank.
But taken at face value, the comments suggest room for further rate hikes. The stock market remains booming. The labor market is strong. Most indicators of financial conditions continue to show little restraint in either lending or borrowing. Growth looks strong.
The market is sending a similar message, with a 70% chance of another rate hike in October and two more hikes priced in between now and March.
Mr. Warsh’s focus on sometimes esoteric market indicators is even more intense than previous chairs, and somewhat reminiscent of former Fed Chairman Alan Greenspan, who was famous for digging deep into everything from corporate capital spending plans to the price of scrap metal.
In his Jackson Hole speech, Mr. Warsh said he was looking at a range of indicators of financial expansion, including credit spreads, the Fed’s senior loan officer poll, which measures banks’ lending appetite, and the availability and demand for credit. His conclusion? Money is easy.
“This helps explain the increase in these loans this year,” he said. “There are few signs of policy restraint in the credit and loan markets.” Easing credit conditions does not necessarily necessitate a rate hike. Under Mr. Warsh’s formula, if inflation is above target, the central bank may have to resort to a private credit system that makes credit too easy.
“You have to be careful about the money that central banks are creating and the money that’s coming out of banks and the financial system,” Warsh said in Jackson Hole. As credit conditions continue to ease, the Warsh framework leaves the door open for further rate hikes. However, rate hikes are only likely if inflation remains high, along with oil and diesel prices.
“The recent increase in commodity prices across the board is also noteworthy,” Warsh said in Jackson Hole. of bloomberg commodity indexa broad measure of commodity prices, has risen more than 30% this year. The situation for some energy products has worsened, with diesel up 83%.
Other Fed officials are moving at a slower pace.
It is unclear whether other members of the FOMC have abandoned their neutral framework in favor of one that more closely aligns with Mr. Warsh’s broader conception of financial conditions. These conditions have always been part of how Fed officials evaluate policy, but few now talk about them as more than just part of decision-making. Former Federal Reserve Chairman Jerome Powell often noted how difficult it is to determine a neutral interest rate, yet he often described interest rates as “reasonably restrictive.”
So far, Mr. Warsh is virtually alone in refusing to predict the outlook for fund rates in a summary of the economic outlook, a so-called dot plot. Many board members also continue to offer their outlook on the economy and interest rates in speeches and interviews, which Mr. Warsh rejects.
This passive attitude highlights the slow pace of the change of government to date. Mr. Warsh has inherited a commission and an economy that he must control, and both are working together to delay the reforms Mr. Warsh wants to introduce.
Reform, which appears to be Mr. Warsh’s long-standing policy priority, is perhaps the slowest. Mr. Warsh has been arguing since at least 2011 that the Fed should reverse the growth of its balance sheet, which now stands at $6.7 trillion. He hasn’t committed to a plan to make that happen, which could mean the Fed sells securities it already owns or lets the bonds mature without replacing them. He resigned from his first term on the Fed board that same year because he was uncomfortable with the expansion, but said he voted in favor of the expansion out of loyalty to the financial institution.
Now that he’s back in charge of leading Fed policy, Warsh finds himself unable to immediately implement his balance sheet reduction plan, even though in theory he could have extracted more stimulus from the economy. Other voters are reluctant to move quickly to reduce the balance sheet, preferring to wait for Warsh’s task force report, according to July FOMC meeting minutes.
Economic and market conditions could also complicate Warsh’s plans. With inflation above the Fed’s target and oil prices soaring, the committee needed to address the price problem quickly, making it the wrong time to test whether Mr. Warsh was right that balance sheet reductions would effectively throttle the economy.
Meanwhile, the yield on the 10-year Treasury note is above 5%, and interest rates on mortgages and other consumer debt are also rising. That makes it a particularly bad time for the Fed to start asking the market for additional mortgage loans and Treasury securities if it were to reduce its balance sheet.
