Meet the new boss, same as the old boss.
With those prophetic words uttered by The Who, America welcomes a new Chair to the Federal Reserve replacing a Burnsian like failure, Jay Powell.
The question becomes what type of Fed Chair does Kevin Warsh intend to emulate or does he actually have a new reform minded program which might actually modernize some of the antiquated thinking which has lead to crisis after crisis since LTCM in 1998?
I. The Greenspan Repeat?
To answer this question, let’s review some of the commentary and statements from Mr. Warsh himself to formulate some ideas.
New Fed Chair Kevin Warsh suggests he may take an Alan Greenspan-style approach at the central bank
The following excerpt from YahooFinance’s article linked above speaks volumes about where Fed policy might be heading:
“I’ve known five of my predecessors in this job, some of them quite well. But Chairman Greenspan was the first to tell me and show me what this role demands,” Warsh said during a ceremony in the East Room. “Like Alan, I intend to fill the role of chairman with energy and purpose, just the way Chairman Greenspan did.”
Greenspan is known for holding rates steady rather than raising them during the internet boom of the 1990s because he saw that inflation was not rising and thus productivity must be increasing, negating the need to raise rates.
The emphasis is this author’s but think about this statement and prior interviews with Kevin Warsh. Warsh’s testimony during his confirmation hearings however revealed this gem which exposes his blind spot in a similar fashion as Greenspan’s during the go-go 1980’s.
Warsh said the Federal Reserve must update its models to account for AI’s accelerating impact on the economy, even as key effects remain uncertain. While he noted that the implications for employment and productivity are still unclear, he warned “we don’t have a long time to do new studies” to anticipate potentially significant shifts in productivity gains or labor market outcomes.
“This is the most disruptive moment in modern economic history in the U.S. and the world,” Warsh told the senators.
Greenspan, like Warsh, thought that the computer boom in the 1980’s followed by the internet boom in the 1990’s would provide sufficient growth to overcome inflationary pressures. Thus why holding rates seemed like a prudent and wise strategy.
The truth is that Greenspan’s Fed started it’s tenure not only with a rate hold, but minor expansion of the Fed’s SOMA balance sheet as stated in this excerpt from the Federal Reserve FOMC minutes of August 18, 1987:
Historically this move in the SOMA looked impressive on an annualized basis during that era, especially as it jumped higher after the 1987 market crash, the reality is it is a minor blip compared to recent actions of the Fed.
Interestingly, this policy in the end would exacerbate what became a disaster in October of 1987. The statement also highlighted economic conditions which sound eerily similar to the current economic situation Warsh is inheriting:
If inflation were higher in that era, like now, one might call it stagflationary. The reality is that 1987 became a conflict between a speculative equity frenzy and a post-early 1980’s boom due to the widespread technological innovations in the post-Volcker shock era of the early 1980s.
Needless to say, if Warsh is going to adopt a Greenspan like approach for his first meeting, the FOMC statement in June might sound something like this from the 1987 FOMC statement:
In other words, way, way back in 1987 even the maestro Alan Greenspan and company had concerns about economic growth with higher inflation but the issues he couldn’t address were well outside of the Federal Reserve’s control at that moment in history.
II. Warsh Might Rinse, but Odds are he Repeats
In this modern era of fiscal dominance, the Federal Reserve is facing a dilemma. While two decades of failing to uphold the regulatory responsibilities assigned to America’s central bank have come home to roost in the form of twenty years of unbridled corruption of free markets, the reality is that Kevin Warsh appears to think that putting new paint on an old building might change the future and restore the Fed’s role as the unofficial Fourth co-equal branch of government.
Let’s start with Mr. Warsh’s desire to adopt the the “trimmed mean core inflation rate” versus the PCE core inflation rate which is currently the Fed’s preferred measure for inflation. While this might sound logical from a broad determination to measure “real” inflation from a monetary policy perspective, when one starts to read the interpretation of this idea, it promotes a lower real inflation rate to justify policy versus improving the lot of the broader public.
The Brookings Institute summarizes the concept succinctly here:
The trimmed mean is an alternative measure of core inflation. It removes outliers by taking the price change of all items in an index, sorting them from smallest to largest, and then cutting off the most extreme observations from the bottom and top of the distribution. The inflation rate is the weighted average of all the remaining items.
Theoretically this sounds good.
Further in the article linked above a good summary of the downside risks to using the measurement criteria is highlighted:
In addition, trimmed mean and median measures, by design, exclude much of the impact of President Trump’s tariffs and much of the energy shock from the war in Iran. These shocks could be viewed as one-time increases in the price level—not the inflation rate—and thus should be excluded from any measure of the underlying inflation trajectory. But these shocks can influence market, business, and consumer inflation expectations, and containing those expectations is a key Fed objective. Moreover, by disregarding price increases due to tariffs or higher oil-related input costs, trimmed mean and median inflation measures “could systematically and substantially understate the inflation experience for a period,” says Krishna Guha of Evercore in a report to clients. Dallas Fed researchers note that trimmed mean inflation might not pick up on “the beginning of broadening inflationary pressures.”
In other words, for extended periods of time, the measurement instrument could serve some useful purposes as a CPI snapshot. However for a supposedly reformed modernized FOMC, it could lead to illogical decisions in the short term which would lead to higher inflationary pressures for longer due to misreading a short term inflationary impulse and increasing the duration of higher prices due to a less restrictive monetary policy.
Another aspect of a potential regime we might see is not just tinkering on the fringe, but wholesale changes to the balance sheet by increasing short term funding activity in the overnight repo market and shorter term treasuries, leaving the long end to actually engage in real price discovery without Fed interference. Should such a course of action be engaged in, a sort of quiet Quantitative Tightening, liquidity on the long end could become an adventure as many bond holders would look to lower that aspect of the risk curve by piling into short term instruments which are far more liquid.
Per this quote from Federal Reserve Governor Michael Barr last week (via CNBC), it should be a 1987esque wake up call as to the risks the US markets might face should such a move become perceived reality:
“I think shrinking the balance sheet is the wrong objective, and many of the proposals to meet this objective would undermine bank resilience, impede money market functioning, and, ultimately, threaten financial stability,” Fed Governor Michael Barr said in a speech last week. “Some would actually increase the Fed’s footprint in financial markets.”
Barr’s thesis essentially is that looking merely at the size of the balance sheet is too narrow – that other issues, such as how it is comprised with respect to duration and composition also matter. Neglecting those issues, he asserts, could have “perverse” consequences such as increased volatility and even the possibility of more interventions from the Fed. At the same time, he said, lowering reserve requirements for banks could destabilize the system.
Emphasis again is this author’s, but it highlights the risks of implementing theory into practice at a time of excess speculative frenzy, difficult international financial conflict, and geopolitical risk.
Lastly, Greenspan never had a press conference and rarely spoke openly about Federal Reserve decisions unless it was during Congressional testimony or after a massive event requiring confidence building measures for the markets (1987 Crash, LTCM, 9/11, etc.).
Per the quote below from this article via Morningstar, odds are the era of the reporters asking redundant questions and some really ignorant ones I might add, could well be over.
Investors and economy wonks watch such press conferences closely. Proponents of regular media appearances by the Fed chair say they allow the central bank to shape the narrative around its interest-rate moves and can help markets digest the Fed’s policies. But some critics – including Kevin Warsh, Trump’s nominee to take over as Fed chair – say Fed officials overcommunicate.
Warsh, who is likely to be confirmed before the Fed’s next policy meeting in mid-June, has suggested he may stop holding the regular press conferences entirely.
While all of this sounds like fun and games, the real inflation rate, the one that American citizens have to enure daily is not showing any signs of abating soon. The projections are that the May CPI-U will come in hot, north of 4% which means the instrument these pages prefer, the Atlanta Fed Sticky Price Core CPI will also jump higher from the 3.1% level.
By no longer having to address the media, wild market fluctuations due to a misstatement or outright Powellesque blunder could add to more stability; on the flip side it does leave Fed actions open to massive interpretation by the old guys known as the bond vigilantes, a tail risk not being taken into account.
III. Repeat
Unfortunately for Chair Warsh, the grandiose plans to immediately reform the Fed, change the management criteria for inflation, and justify cutting the Fed Funds Rate is going to be restricted by geopolitical events, real inflation, political pressure from the masses via Congress, and of course the real boss, the bond market.
For those hoping for a quick rate cut and moving into a longer term moderating Fed Funds Rate, I think those parties will be quite disappointed. The short term inflationary impulse introduced by the consequences of the trade and tariff war along with the spike in petrochemical product prices will mean higher prices for longer throughout the summer, handcuffing the Fed as the bond market screams “higher rates for longer” and the failure to address the exploding deficit along with out of control spending which is no where to be found in Washington.
Thus for the time being, look for Kevin Warsh to simple make cosmetic changes to Fed policy, put the data into a delayed rinse cycle, and repeat the same policies of Sir Alan Greenspan of the late 1980’s; which eventually led to a crushing recession in July 1990 to March of 1991 at the culmination of another era of speculative excess and financial fraud which included the Savings and Loan Crisis.
By the time disinflationary conditions return to the economy, the Federal Reserve’s reaction function will be too little too late and President Trump will once again resort to Fed bashing as the economy begins to grind into a stagflationary period then potentially outright deflation as the credit cycle ends and the lower leg of the economic caste introduces the long forgotten concept of demand destruction to the markets once again.
Business cycles can be postponed, but eventually the Kondratieff winter must be allowed to arrive. This time is no different and it will be up to the “new and improved” Federal Reserve to modernize and adapt to the new economic reality or continue to throw stale bread at a dying eagle, instead of encouraging the recovery by allowing the zombies to finally be eradicated from the US economy.
