Quick Thoughts on Warsh

Fed Chairman Kevin Warsh gave a speech this morning at the Fed's annual monetary policy conference at Jackson Hole. Here are my thoughts:

• Price action as of ~11:30 EST

  • Bear flattening in the curve--6m +4 bps, 2y +7 bps, 10y +1.5 bps. Most of the move came towards the beginning of the speech, with 2y up +6 early on.
  • Post-speech, Fed funds futures prices currently imply ~32 bps worth of hikes by the end of the year and two full 25 bp hikes over the next 12 months.

• Direction and pace of monetary policy:

  • Direction: Warsh opened by talking about "hikes," as in going on walks in the mountains. He referenced two kinds of hikes--intense hikes like he did with former Fed Vice Chair Don Kohn, or leisurely hikes like he did with Ben Bernanke. This early reference to hikes probably drove the initial selloff in rates, as Warsh was telegraphing a hawkish stance.
  • Pace: His rhetorical question--"do a wellness check and ask yourself: 'is this a Kohn day or a Bernanke day?'"--I interpreted as him implying that this is a Bernanke day, where we are going on a hike for sure but it will be a leisurely one.

• On AI: Warsh reiterated the potential for substantially higher growth from AI, but had little else to say. Some Trump-appointed officials have suggested that large productivity gains unleashed by AI--shifting the supply curve to the right--can justify lower policy rates. Warsh did not explicitly follow that thread, which he could have used as justification for a dovish view.

• Forward guidance, consistent with Warsh's prior remarks:

  • Necessary at the time of the GFC, but a "practice that has overstayed its welcome."
  • Believes making commitments on the path of policy inhibits freedom of maneuver, if conditions change.
  • Warsh referenced a "hall of mirrors" problem with respect to forward guidance, where market participants rely on Fed projections of the path of rates and economic variables in developing their own forecasts and executing their own trades, and the Fed simultaneously relies on market price signals in assessing the economy. In this case, both the central bank and markets are caught in a feedback loop, with nobody making independent judgments about the economy.
  • Warsh also explicitly rejected the use of mechanical reaction functions like a Taylor rule, as the factors relevant to executing monetary policy change over time.
  • Warsh did not reference what in my opinion is the best argument against forward guidance, which is that unconventional policy tools suppress volatility in financial markets and over time, increase fragility in the system (see: the cash-futures basis trade). "Stability begets instability," to paraphrase Minsky.

• Warsh outlined six principles that guide his thoughts on monetary policy. A couple of points that stood out to me:

  • Principle 1 - He prefers to look at trends, rather than static data points
  • Principle 3 - "The Fed's price-stability objective of 2 percent, as measured by the personal consumption expenditures (PCE) price index, is a firm, fixed target." The market will interpret this as a strong commitment to price stability, and probably contributed to a couple of basis points of higher yields after Warsh's original "hiking" comment.
  • Principle 5 - "Fifth, short-term interest rates are the predominant tool to achieve the dual mandate." No forward guidance, no QE. I'll continue to pay attention to FOMC commentary about reserve management purchases--does Warsh want a change, and can he bring the rest of the Committee along?
  • Principle 6 - "We should pay attention to money created by the central bank and money that comes from the banking and financial systems." I am not sure exactly what Warsh means by this, but if he is referencing a greater emphasis on a Mehrling/Pozsar "money view," I think this is a good thing.

• On the economy, Warsh believes that it has been resilient in holding up to shocks:

  • Strong capex and profit margin growth. Warsh will be watching rate of change in growth rates. If we see sharp deceleration in these metrics, we might see Warsh start to argue for cuts.
    • My view: business profits are correlated with wages and prices. Businesses increase their profits by paying employees or vendors less and charging customers more. Margin expansion that comes at the expense of customers and employees (voters) is tolerable only up to a point, before the political environment forces it into reverse. You can only squeeze people so much before they decide enough is enough and guillotine you.
  • Referenced tight credit spreads on corporate bonds and leveraged loans, indicating easy financial conditions. Probably true, but given how much issuance is happening in opaque financing markets, I think there is a lot of adverse selection going on here.
  • Seems unconcerned by low job growth numbers, as the labor supply itself is barely growing. I agree.

• I read Warsh as mostly hawkish on inflation.

  • "And while this summer's PCE and CPI readings were better than expected, they do not tell me that underlying trends have meaningfully improved."
  • Warsh did point to market-based measures of inflation (swaps) showing that inflation expectations remain well-anchored, but cautioned that inflation expectations can look fine until they suddenly aren't fine. I agree--we have seen sudden "phase shifts" in inflation swap markets before.
  • "There is one signal nobody can miss: The responsibility for 65 months of sustained, elevated inflation sits squarely with the central bank."
  • I interpreted all of this as, if Warsh doesn't see the underlying inflation trends moving towards target at sufficient speed, he's ready to vote for a hike.

In conclusion: A September hike is definitely live, and I expect reserve management purchases to become a greater point of discussion within the FOMC over the next few meetings.