Former Federal Reserve Governor Kevin Warsh’s column in Tuesday’s Wall Street Journal was so riddled with errors and misperceptions that it is hard to believe he was actually a governor.
Warsh wants the Fed to announce a “practicable long-term strategy and stick to it,” claiming they have offered many such plans but never stuck to them. I don’t agree. The Fed has a plan, but Warsh just refuses to see it.
The former governor’s first critique:
A year ago around this time, the U.S. stock market fell about 10%. The Fed reacted precipitously, reversing its announced plan for 2016 of four quarter-point rate increases. But when prices rallied near the end of the year, the Fed decided it wouldn’t look good to let the moment pass without raising rates. It raised its key interest rate by a quarter point in December.
The Fed did not reverse its announced plan. The rate forecast contained within the Fed’s Summary of Economic Projections is just that, a forecast, not a plan. Incoming data triggered a revision of that forecast. And, contrary to the narcissistic belief of many market participants, it wasn’t all about them. Falling equity prices were just one of many data points that changed the course of policy. The Fed faced a very real slowdown in activity. Andrew Levin, former Fed economist, for instance, described the economy as operating at stall speed. Note that output growth slowed markedly during 2015 and into 2016:
The unemployment rate stalled out:
And inflation remained tepid:
If the Fed updated their forecast, it was for good reason.
Warsh follows with another instance of the Fed supposedly reversing course:
In late October, Fed Chair Janet Yellen expressed willingness to run a “high-pressure economy” to push the unemployment rate lower and inflation higher. Yet in a speech two weeks ago, she said that allowing the economy to run “persistently ‘hot’ would be risky and unwise.”
Yellen never expressed a willingness to run a high-pressure economy. That was always a complete misrepresentation of her comments. In that speech, she was simply proposing a research agenda for macroeconomists, including the topic of the influence of aggregate demand on supply. Had anyone actually read the speech (and I have to assume Warsh did not), they would see that she did not provide any policy proposals. Her subsequent comments were nothing more than an effort to set the record straight, not a shift in position.
Warsh uses the above episodes to claim that the Fed lacks a strategy:
Changes in judgment should be encouraged, but they ought to indicate something other than day trading or academic fashion. They must be rooted in strategy. Otherwise, the real economy winds up worse off…
…The Fed’s technocratic expertise is no substitute for a durable strategy. This make-it-up-as-you-go-along approach causes many Fed members to race to their ideological corners, covering themselves as hawks and doves…
The problem here is that the Fed does have a strategy, but Warsh refuses to see it. Specifically, incoming information alters the Fed’s economic forecast and, in accordance with a basic Taylor Rule, the Fed’s rate forecast with the goal of meeting the dual mandates over the medium term. Indeed, San Francisco Federal Reserve economists Fernanda Nechio and Glenn Rudebusch show that the Fed altered its rate forecast systematically in response to incoming data in this manner. That data brought the Fed’s original forecast for four rate hikes down to the actual one rate hike.
There is indeed a strategy. It is not the Fed that is too focused on the near-term. It is Warsh that is too focused on the near-term.
Warsh proposes five reforms for the Federal Reserve, beginning with:
First, the Fed should establish an inflation objective of around 1% to 2%, with a band of acceptable outcomes. The current 2.0% inflation target offers false precision. According to the Fed’s preferred measure, inflation is running at 1.7%, only a few tenths below target. The difference to the right of the decimal point is too thin a reed alone to justify the current policy stance. It also undermines credibility to claim more knowledge than the data support.
This one reveals Warsh’s true intentions – the current inflation target does not support his desire for higher rates, so he wants to move the target! Moreover, the current target does not offer false precision. No one at the Fed believes they can consistently hit two percent. And being below two percent has not stopped them from raising rates. In practice, the Fed will tolerate misses within a reasonable (25bp) range around two percent as long as forecasted inflation is trending toward target. That’s the medium-term strategy Warsh claims to be so concerned about.
Second, the Fed should adjust monetary policy only when deviations from its employment and inflation objectives are readily observable and significant. The Fed should stop indulging in a policy of trying to fine-tune the economy. When the central bank acts in response to a monthly payroll report, it confuses the immediate with the important. Seeking in the short run to exploit a Phillips curve trade-off between inflation and employment is bound to end badly.
It is a misperception that the Fed acts impetuously on the most recent data. They use that data to update their forecast in a systematic fashion (see above). I generally excuse most people from not understanding this distinction. It is a difficult concept and, quite frankly, one that the Fed does a poor job communicating. Warsh, however, has no such excuse.
For his third reform:
…the Fed should elevate the importance of nonwage prices, including commodity prices, as a forward-looking measure of inflation. It should stop treating labor-market data as the ultimate arbiter of price stability…A material catch-up in wages after a long period of stagnation need not trigger a panicky response.
I don’t think Warsh understands the foundations of Fed’s approach to inflation forecasting. From Yellen’s lengthy discussion of the topic in September 2015:
To summarize, this analysis suggests that economic slack, changes in imported goods prices, and idiosyncratic shocks all cause core inflation to deviate from a longer-term trend that is ultimately determined by long-run inflation expectations. As some will recognize, this model of core inflation is a variant of a theoretical model that is commonly referred to as an expectations-augmented Phillips curve. Total inflation in turn reflects movements in core inflation, combined with changes in the prices of food and energy.
Wages aren’t in that description. Wages are primarily a guide to estimating full employment (economic slack). Rising wage growth indicates the economy is approaching full employment. Wage growth in excess of the inflation target plus productivity growth raises warning signs that the economy is operating beyond full employment. Also, commodity prices are included as idiosyncratic shocks. Finally, the labor market data is very clearly not the ultimate arbiter of price stability. In the long-run, inflation expectations are the ultimate arbiter of price stability.
Warsh’s next reform:
Fourth, the Fed should assess monetary policy by examining the business cycle and the financial cycle. Continued quantitative easing—which Fed leaders praise unabashedly—increases the value of financial assets like stocks, while doing little to bolster the real economy. Finance, money and credit curiously are at the fringe of the Fed’s dominant models and deliberations. That must change, because booms and busts take the central bank farthest afield from its objectives.
Note that earlier Warsh complained that the Fed reacted to the financial cycles – easing policy when equity prices were falling and vice-versa. Now he wants the Fed to react to those cycles? In actuality, the Fed does take financial considerations seriously. See, for example Governor Jerome Powell here. Vice Chair Stanley Fischer here. Governor Daniel Tarullo here. Go back to the work of former Governor Jeremy Stein. And with regards to quantitative easing, the Fed would argue that their actions have indeed bolstered the real economy. And while busts in particular do take the Fed far away from its mandate, so too would strangling the economy to address a theoretical financial risk. Incorporating a financial stability term in the Taylor Rule is easier said than done.
Fifth, the Fed should institutionalize its new strategy and boldly pursue it with a keen eye toward the medium-term.
As I noted earlier, the Fed does have a strategy, the focus of that strategy is the medium run forecast, and the Fed changes their behavior in a systematic way to pursue that strategy. In short, the Fed’s already acts in accord with this supposed “reform.” Move along, folks, nothing to see here.
Bottom Line: If you want to understand the Federal Reserve and monetary policy, I don’t think reading Warsh’s op-ed gives you much to work with.