I like Kevin Warsh, the newly appointed Chairman of the Federal Reserve (the Fed). I liked Jay Powell, too. They are both clearly smart. Additionally, while I don’t really know, they both seem like men of integrity. To me, this matters – a lot.
Kevin Warsh is trying something new at the Fed. In recent years, the Fed Chairman and other members of the Federal Open Market Committee (FOMC) – the rate setting arm of the Fed – have given what’s called “forward guidance” to financial markets. This guidance is essentially insight into where the FOMC and its members currently think the overnight Fed Funds target rate will be in future months. The FOMC adjusts this targeted trading range to provide price stability and maximum employment for Americans. And other interest rates, and resulting borrowers, are impacted by the Fed Funds rate.
Forward guidance was introduced after the Global Financial Crisis when interest rates were near zero. It became an important monetary tool to communicate future Fed policy, avoid surprises and keep markets stable. However, Warsh’s view is that markets have become too reliant on forward guidance. As he phrased it, markets stopped watching the ball and began watching the referee.
The market sets trading levels based on a whole slew of variables. Warsh believes market prices should reflect investors’ own assessment of incoming economic data rather than primarily reflecting expectations of how the Fed will react. Of course, this is always part of a trader’s analysis – guessing how the Fed will respond to inputs. Warsh is encouraging participants to think for themselves – like they historically have. My interpretation is he wants the FOMC to benefit from what the market thinks versus constantly leading it. In effect, his message is: “Quit watching only me – I want to watch you.”
To be sure, the bond market is a complex beast. Interest rates and borrowing costs depend on so many variables: credit quality, supply and demand, the economy and geopolitical events, to name a few. And one could make the argument that the market is overlooking some important data.
Take one variable for example – the amount of US federal debt. Issuance of US Treasury securities remains historically high because the US federal deficit is at an all-time high and growing. Greater Treasury issuance can put upward pressure on interest rates because the market must digest a larger supply of securities, although that effect is often offset – or reinforced – by inflation expectations, economic conditions and investor demand.
Do US borrowing costs reflect a true clearing level, or are they distorted by expectations regarding future Fed actions? Are the markets scrutinizing the data or the Fed?
When you take something away, people squawk. And many market participants have been squawking about the removal of the forward guidance. It’s like a new dating relationship and both sides are adjusting to different expectations. Warsh is setting new boundaries and hoping the market will rely more on its own interpretation of economic data than on Fed signals. There will likely be a period of adjustment, and some give and take, as both parties establish trust. We’ll just have to watch and see.
In the meantime, I’m hoping my impression of Warsh’s integrity is right. Jay Powell exhibited integrity in spades. In my view, it’s one of the most important qualities a Fed Chair can possess.
