(Bloomberg) -- Kevin Warsh's embrace of financial markets to help the Federal Reserve do its job would mean trading more precise policy tools for a blunt instrument.
It can work, but it's an inefficient way to bring down too-high inflation and comes with trade-offs, economists and former officials say.
Central bankers typically use their benchmark federal funds rate to steer the economy because it allows for a level of fine-tuning that doesn't exist when the market is left to its own devices. And, as then-Fed Governor Jeremy Stein said in a 2013 speech, it "gets in all of the cracks." By raising the overnight lending rate, the Fed can affect a variety of other market rates.
"It's really a question of, does the central bank want to be in control or not?" said Mark Cabana, head of rates strategy at
"If you rely on the long end of the curve to just do its thing then you don't have control," he added. "You have much less ability to try and bring rates down or exactly calibrate how rates go up."
Fed officials last week held rates steady in a range of 3.5% to 3.75%. In his second press conference since becoming Fed chairman, Warsh repeatedly highlighted moves in the bond market. "While at some level we haven't done much in 42 days, the markets have done quite a bit," he said, stopping short of an outright endorsement of the rise in Treasuries yields in that period.
Warsh plans to stick with his communications strategy even after an abrupt bond market selloff in response to his messaging so far, the Financial Times reported on Thursday, citing people close to Warsh.
Warsh acknowledged he's made mistakes since taking up the position of Fed chairman in May, including by not reinforcing his key messages on price stability, according to the newspaper. The Fed chairman would be prepared to raise interest rates in September if inflation data due over coming weeks comes in hot, the FT reported.
Leaving markets to do the job of bringing down inflation can stoke levels of volatility or pricing overshoots that unduly damage the economy. A whiff of that was seen in the aftermath of Warsh's briefing, when 30-year bond yields jumped to the highest level in 19 years. Unrestrained by guidance from the Fed chief on how he aims to contain inflation, it could risk getting to levels that wallop the housing market and corporate borrowers.
"Be careful what you wish for," as George Catrambone, head of fixed income at DWS Americas, put it.
Another scenario: traders may doubt policy action will prove forthcoming, leaving markets misaligned with the settings needed to contain price pressures. That could ultimately force more drastic Fed measures.
What Bloomberg Strategists Say:
"Warsh's changes to how the Federal Reserve conducts policy are likely to steepen the Treasury curve further, leaving the front end tied to incoming data while the long end absorbs a growing credibility and supply premium."
"If the markets think in order to restrain demand you need to tighten policy and he doesn't do it — he just relies on the markets — the markets are going to take that tightening out," said Don Kohn, a former Fed vice chair who advised and worked closely with Alan Greenspan.
And that's already starting to materialize. Before Warsh's press conference last week, markets were pricing in about a 70% chance of a rate hike in September. Those odds are now below 60%.
Warsh argues that by not providing investors with insight into future Fed policy, they'll then react to incoming economic data without being encumbered by messaging from the central bank. That market reaction will, in turn, provide Fed officials with a clearer picture of how they should adjust their policy.
But Warsh has taken his no-forward-guidance edict one step further — by refusing to explain what he thinks about data and how the Fed might react to different developments.
Treasury Secretary Scott Bessent, who vetted Warsh and other candidates for the job, rebuffs the angst among Fed watchers. He said on CNBC Tuesday that this is a period of "detox" from years of forward guidance and massive Fed purchases of Treasuries that left markets unable to pick up on things like the 2021 inflation surge.
Warsh and Bessent both have harkened back to the era of Greenspan, who was famous for accomplishing what he wanted while not giving the market too much indication of what he was going to do.
That approach isn't universally shared. An increasing number of Fed officials are seeing the need for direct action. Three policymakers dissented at the July 28-29 Federal Open Market Committee meeting in favor of a hike. A fourth, St. Louis Fed President Alberto Musalem — who doesn't vote on rates this year — also backed a move.
Bigger Response
Musalem went on to sound an alarm on the market's post-meeting reaction, in an interview with the Financial Times. The jump in yields at the end of last week "emphasized to me that we need to continue to earn our credibility every day with both effective communications and actions as needed."
In the long run, if the Fed sows distrust with markets about being willing to act on its own, that may end up forcing it to do more, critics say.
"One of the values of formal guidance is that you do not have to act if the market trusts your ability to act in the future," said Brij Khurana, a portfolio manager at Wellington Management. "But if you remove that, then you do have to do much more with policy rates to get the same economic reaction."
Minneapolis Fed President Neel Kashkari pointed to a similar tradeoff in a statement detailing why he was one of the three dissenters last week.
"If inflation remains elevated, in my view, a potential series of small policy moves would be better than waiting and eventually concluding that even bolder actions were necessary," he said.
Fed watchers will be keenly monitoring Warsh's expected speech at an annual economics conference later this month in Jackson Hole, Wyoming, for any pivot by the chairman.
"Warsh gets another shot at it in a couple weeks," said Alex Payne, a senior portfolio manager at Vanguard. "What I would expect is that he is going to really anchor the market's focus on getting inflation back to 2%."
--With assistance from Enda Curran.
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