Today, we offer another in a series of guest posts on the Fed and its path forward.
Today’s writer, my friend Martin Barnes, has around 50 years of experience as an economist, mostly in the financial sector. He began his career in January 1973 in the Forecasting Division of British Petroleum in London. Then, after spending 10 years as chief economist for a major UK stockbroker firm, he joined Montreal-based BCA Research in late 1987, spending 18 years as editor of the flagship Bank Credit Analyst report. BCA Research is one of the world’s largest independent investment research firms.
Martin retired from BCA in October 2021 after 34 years in the firm, most recently as chief economist. During his long career, he published extensively on economic and financial issues and presented at major conferences around the world. He was a regular attendee at the Federal Reserve’s prestigious Jackson Hole Symposium and has testified to the US House Banking Committee on monetary policy. Martin continues to write occasionally for BCA Research on key economic and market topics.
On a personal note, I must add that Martin was a regular attendee at Camp Kotok in Maine and helped establish the “eel skinner” award.
Here’s Martin on some of the changes that Fed Chair Kevin Warsh is bringing to the Fed.
The Fed: Under New Management
by Martin Barnes
New head honchos joining established companies inevitably want to make their mark by shaking things up a bit. The new Federal Reserve Chairman, Kevin Warsh, is no different so we should not be surprised by his plans to examine and potentially change many aspects of how the central bank operates.
Sound monetary policy is critical for economic and financial stability so central bank actions should never be protected from detailed scrutiny. The Fed is generally staffed and governed by serious people doing their best in a difficult job. But there is always scope for improvement, and there is nothing inherently wrong in Warsh’s establishment of five task forces to examine communications, balance-sheet policy, data, productivity and jobs, and inflation frameworks. And some serious economic heavyweights have been co-opted to examine these issues.
Communications
On this issue, I fully support Warsh’s decision to scale back forward guidance. Former Fed Chairman Ben Bernanke’s 2012 introduction of the so-called dots providing FOMC projections for the economy and the fed funds rate was a step too far in pursuing his desire to provide more transparency about the direction of policy. The Fed’s economic forecasts rarely differ from the general consensus view, so they add little value. Meanwhile, the cacophony of overly frequent speeches and commentary by Fed officials often creates more confusion than clarity.
There have been widespread calls for Warsh to provide more information about the economic triggers he would use to justify changes in policy – i.e. his reaction function. Again, I support his approach to merely state that he will vigorously pursue the Fed’s mandate of price stability and full employment. Being precise about the levels of inflation or unemployment that would trigger policy shifts would not be helpful, as there are always other factors to consider. Market participants are well equipped to determine when inflation and/or unemployment are moving into problematic zones. If the markets start to price policy moves that differ from the Fed’s intentions, that can be easily corrected by an appropriate Fed statement.
Balance Sheet Policy
The task force on balance-sheet management will face challenges, as two of its members seem to have differing perspectives. In his presentation to the 2016 Jackson Hole Symposium, Jeremy Stein argued in favor of the Fed’s maintaining a large balance sheet indefinitely and being proactive in using it to maintain financial stability. On the other hand, Raghuram Rajan has warned about the dangers of endless quantitative easing (QE). Meanwhile, Warsh has been a vocal critic of QE, railing against it when he was a guest speaker at the 2016 BCA Research investment conference.
The reality is that the Fed will always follow the maxim of “doing what it takes” in the face of severe economic and/or financial turbulence. Once interest rates are at the zero bound, boosting the balance sheet is really the only option the Fed has to try and restore stability. Regardless of what the task force concludes, QE will be back in the next crisis – especially if it is triggered by a fiscal-related revolt by bond investors.
Data
It is not clear what a data task force is supposed to achieve. The Fed already has access to all available data, supported by anecdotal reports from high-level business contacts in the various regions. Technology has increased the flow of real-time data on economic and financial transactions, and presumably the Fed can get access to that. Unfortunately, the sad reality is that the quality of policy decisions does not improve in line with the availability of data. Knowing how the economy is performing today is not necessarily a good guide to how it will perform tomorrow, and the Fed’s forecasting ability is just as flawed as everybody else’s.
Productivity and Jobs
This task force is charged with assessing the economic impact of new technologies such as artificial intelligence (AI). The three technology experts on this mission will no doubt conclude that AI promises huge potential gains for the economy, albeit with risks. But it is far from clear how this will make the Fed’s job any easier. Yes, former Chairman Alan Greenspan made a good call in the 1990s when he refrained from tightening policy on the grounds that rising productivity would keep inflation in check. But that strategy proved to be a temporary benefit as productivity growth subsequently declined; and let’s not forget that he erred by keeping policy too accommodative in the first half of the 2000s, providing fuel for the housing bubble.
There is no doubt that AI is going to have important economic, social, and financial effects. However, this is a very long-term story, and day-to-day Fed policy will be driven by the usual suspects of short-term economic and financial developments. In other words, the task force’s conclusions will be of interest but are unlikely to add much value to understanding near-term policy actions.
Inflation Frameworks
The fifth task will revisit how the Fed understands and responds to the drivers of inflation. You might think that central banks should already have a good grasp of what causes inflation, but that question remains a source of uncertainty and debate. The old Milton Friedman dictum of inflation being always and everywhere a monetary phenomenon was abandoned by the Fed a long time ago. Instead, the Fed seems to have followed the simpler stance of reacting to the actual trend in its favored inflation measures.
No doubt the task force will get into the weeds of which inflation measure is the best yardstick for policy, and there are many choices. But this is a rather fruitless road to travel, and I am reminded of Supreme Court Justice Potter Stewart’s famous quote about obscenity – “I know it when I see it.” In other words, it should be obvious when inflation is becoming a problem. Yes, supply and demand shocks can muddy the waters, as it can be difficult to determine whether these are transitory or structural. But that is why forecasts are always destined to go astray and no task force can solve that problem.
Conclusion
In sum, we should not expect much to change as a result of task-force deliberations. Chairman Warsh will earn credibility by his actions rather than by his words. There is no reason to doubt his sincerity in emphasizing his commitment to a 2% inflation target, and further rate hikes are likely in the coming year. The real test will be how the Fed reacts in the next economic/financial crisis. At the end of the day, maintaining stability in the banking and financial system will always take priority over controlling inflation. Given the high odds of a fiscal crisis in the next few years, QE will return, and maintaining a 2% inflation target will prove unachievable despite Warsh’s best intentions.
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