On My Mind: One Flew Over the Dove’s Nest

Kevin Warsh not only talks like a hawk, he also walks (or rather, flies) like one. Since taking over as Federal Reserve (Fed) chair in late May, Warsh repeatedly emphasized his commitment to bringing inflation back to target. Last week he followed through with action, leading the Federal Open Market Committee (FOMC) in a unanimous decision to increase the fed funds rate.

When he took the position, many observers assumed he would be a dove. I believe many felt he had been tainted since he had been appointed by US President Trump, who had been quite vocal about his desire to see lower interest rates. These suspicions, which I never shared, can now be put to rest. As I have argued in previous articles, Kevin Warsh is probably the most hawkish Fed chair we've seen since Paul Volcker.

The FOMC meeting, in my view, offered three important insights.

The first insight is that we're likely to see one or two more rate hikes in this cycle. Warsh offered a bullish assessment of the economic outlook, noting that the US economy has been strengthening and that the employment side of the Fed's mandate is in good shape with limited downside risk. Inflation, on the other hand, has been too high for too long, and data over the last few months give no indication that it might be coming down—to the contrary, inflation risks are on the upside, including from commodity prices and geopolitical turmoil. He also repeated that he would be “hard-pressed” to describe broad financial conditions as restrictive. All in all, a quite hawkish assessment.

This is reinforced by two important signals. The FOMC statement noted that the rate hike removes “a dose of accommodation,” something that Kevin Warsh repeated during the press question-and-answer. This suggests that there likely is more accommodation to be removed. And in response to a question, Warsh noted that he had been steadfast in stressing the Fed’s commitment to delivering price stability and that “today’s action starts to show we are serious about this,” where “starts” also suggests this might be the beginning of a series of actions.

This also offers an important second insight into the Warsh Fed’s communication strategy. Warsh has rejected the use of forward guidance from day one, something he reiterated in this latest press conference. At the same time, the language I've mentioned above seems to indicate quite clearly that more rate hikes are possible, if not likely. I don't see a contradiction. Forward guidance amounts to a near unconditional precommitment to future policy moves; once those get built into market expectations, the Fed's hands are tied. What the Fed seems to be doing here is a more delicate balancing act: A clear message on its assessment of the economic situation and the resulting policy bias, combined with the understanding that future policy moves will also depend on new data and information.

The third insight is on how the Fed assesses and weighs economic data. Warsh emphasized that his Fed looks at trends and will not get excited about individual data points, and suggested that financial markets and media should do the same. That, I think, will take some time. It is in the nature of financial markets to try to immediately price in new information, and data points on inflation, employment, and growth constitute very relevant information. Still, Warsh’s warning is this type of information is unlikely to sway near-term policy decisions.

A few more considerations stand out.

Investors and analysts have been asking for the Fed's reaction function. Warsh has, rightly, in my view, declined to provide one, but he is offering greater clarity on the Fed's decision-making process— “a discipline and a set of principles,” as he puts it. Overall, I think this press conference marks a meaningful early step toward redefining the dialogue between the Fed and the markets.

Fiscal policy remains the elephant in the room. Commenting on the rise in long-term yields, Warsh identified as the key drivers the strength of the US economy, the competition for capital, and the heightened geopolitical risk. On the competition for capital, he emphasized the role of artificial-intelligence-related investment—but this implicitly underscored the role played by the large funding needs of the Treasury. If left unaddressed, the large US fiscal deficits will remain an important source of upward pressure on yields, in my view.

I think we should also take seriously Warsh's commitment to reshape other aspects of the Fed's operations. Here, I'm thinking of the ongoing work of the task forces on issues ranging from data, inflation measurements and assessments, the impact of innovation, and the transmission of monetary policy.

The last element, the transmission of monetary policy, will be especially worthy of attention. In the September FOMC press conference, Warsh said that he does not see a conflict between the employment and the inflation sides of the mandate. In other words, he believes the Fed can bring inflation back to target without moving the economy away from full employment. He also said that tighter monetary policy can contain second-round effects from supply shocks and stop broader inflation pressures within the economy. We're accustomed to thinking that this requires some reduction or deceleration in economic activity and therefore employment. Warsh has rejected this Phillips-curve-based view but has not yet articulated a different view on the transmission of monetary policy to the inflation objective, so this will be interesting to follow.