Regime Change Comes to the Federal Reserve
Kevin Warsh took the first steps this week on his quest to lead the Federal Reserve out of the dark ages.
The new chairman of the Federal Reserve has argued for over a decade that the Fed’s communications strategy, especially its tools for providing so-called forward guidance about monetary policy, needs rethinking. He’s argued that central bankers talk too much, that forward guidance has gone astray, and that the Fed’s preeminence in markets and the economy should be pared back.
In a talk to investors last year, Warsh put his advice for the Fed bluntly: “Stop talking so much. More thinking, less talking.”
Warsh Plots Against the Dots
At his first press conference as Fed chair, Warsh put that into practice. To the obvious frustration of the reporters gathered in the briefing room at the Fed headquarters, Warsh steadfastly refused to provide guidance about where the Fed’s policy might go next. He noted that he had declined to submit a forecast for the Fed’s Summary of Economic Projections, identifying himself as the missing dot from the so-called dot plot. The first policy statement of his Federal Open Market Committee (FOMC) was pared down to just the essentials, with no statement about Fed expectations for the economy or rates.
This is no small change. And Warsh made it clear that it is just the beginning. He hinted that he is likely to stop the practice of holding press conferences after every FOMC meeting, an innovation introduced by his predecessor and now colleague on the Fed board, Jerome Powell. Perhaps he will move back to the every-other-meeting schedule followed by Ben Bernanke and Janet Yellen. Or perhaps he’ll do away with the regularly scheduled press conferences altogether, gathering reporters only when necessary to announce some new policy.
“I had a great old mentor named George Shultz, and his mantra was press conferences are useful, but when you have one, you want to make sure you have something important to say,” Warsh told the gathered reporters.
He also hinted that the dot plot might not be long for this world. For the uninitiated, the dot plot is a chart in the Fed’s Summary of Economic Projections (SEP) that marks off with anonymous dots where the 19 official participants at FOMC meetings—the voting members plus the other regional Fed presidents—think interest rates will be at various points in the future. Indeed, it’s possible the entire SEP might be scrapped.
The Rise of Forward Guidance from the Ashes of the Financial Crisis
Not surprisingly, Warsh’s challenge to the status quo has provoked objections from journalists and analysts who have grown accustomed to the way things have been done for nearly two decades. “Does less talk at the Fed mean more noise for markets?” asked a headline in Reuters. The Wall Street Journal reported that “to several Fed watchers, he had stretched a defensible objection into something broader, discarding not just predictions about the next move but any account of how the committee will reason its way to a decision.”
Even before he assumed office, reporters were rushing to quietly criticize Warsh’s position. “Warsh signals that he would lead a less-transparent Federal Reserve,” a headline on Yahoo! Finance declared in April after Warsh had testified at his confirmation.
It’s worth taking a moment to reflect on why the Fed started talking so much and how forward guidance and its broader communication strategy became such a prominent feature of central banking. Before the 1990s, the Fed was deliberately opaque. Markets often had to infer FOMC decisions—whether the Fed was tightening or loosening policy—from open-market operations. That started changing in 1994, when the FOMC began issuing post-meeting statements. It wasn’t until 1999 that the Fed began including forward-looking language about the “tilt” or “bias” of policy.
When the financial crisis hit and the Fed’s policy rate went to zero, the Fed began to put into practice something that had been developed in theory by economists like Gauti Eggertsson and Michael Woodford and actually tried out by Japan’s central bank. Because it is assumed a central bank cannot effectively push its policy rate below zero, economists had worked out an idea of how to ease monetary policy and stimulate the economy through other means. And that idea was forward guidance.
The quick version of it goes like this. When the short rate is stuck at zero, the central bank can still stimulate demand by promising to keep rates lower in the future than it otherwise would. The Fed would commit to going beyond the usual monetary policy rules to keep its policy rates “lower for longer” in order to stimulate current demand.
In December 2008, the Fed cut the funds-rate target range to 0 to 0.25 percent and said weak conditions were likely to warrant exceptionally low rates “for some time.” The minutes show the committee explicitly discussed how to talk to the public and markets about the new regime.
As time passed and the economy continued to stagnate, the Fed’s forward guidance became more explicit. In August 2011, the FOMC said conditions were likely to warrant exceptionally low rates “at least through mid-2013.” In January 2012, it pushed that date out to “late 2014.” Later in 2012, the Fed adopted threshold-based guidance, saying rates would stay near zero at least as long as unemployment remained above 6.5 percent and inflation projections stayed contained.
And the Fed rolled out a host of new communications tools. In April 2011, then Chairman Bernanke held the first post-FOMC meeting press conference. In January 2012, it formally adopted a two percent inflation goal and explicitly said that clearer communication was a way to reduce uncertainty, improve policy effectiveness, and enhance accountability. The dot plot also arrived in 2012, giving markets a quarterly set of individual rate projections. The projections were formally nonbinding, but they were in fact meant to be taken as a promise regarding monetary policy because that’s how the forward guidance theory works. The market has to believe you’ve committed to your policy path.
Of course, the Fed did not confine itself to projections and promises. It also rolled out the large-scale bond purchases that became known as quantitative easing. But even this was a form of communication strategy. Despite their vast size, the bond purchases themselves did not really do much to stimulate the economy. But the Fed’s buying hundreds of billions of dollars of bonds was seen as helping convince the market of its dedication to keeping rates exceptionally low.
Did Forward Guidance and QE Even Work?
Now is a good time to note that it’s still not clear how effective any of this really was. Defenders of the new communications strategy say that it prevented the financial crisis recession from becoming a much deeper depression. But the Fed regularly failed to meet its two percent inflation goal, regularly undershooting. And the economy remained extremely sluggish despite all the guidance, dot plots, and bond buying — so sluggish that liberal economist Larry Summers decided that the economy had entered into a period of “secular stagnation.” Cynics might say that this was just a way of avoiding facing up to the failure of the Biden administration’s fiscal stimulus and the new jaw-jaw monetary policy to actually stimulate growth. Some critics believe that these policies actually backfired, prolonging the slump, perhaps because what they communicated to markets, households, and businesses was that the Fed viewed the economy as still being in dire straits.
What’s truly incredible is that all these crisis-era programs outlasted the crisis itself. Instead of being retired, they became part of the basic machinery of the Fed. The dot plot, calendar guidance, threshold guidance, press-conference hints, and carefully engineered statements turned a crisis workaround into a standing operating procedure. The enormous balance sheet led to a new monetary regime of super-abundant reserves that eventually killed off the reserve requirement for banks altogether and rendered the Fed’s main policy tool—the benchmarking of the federal funds rate—redundant, forcing the Fed to use interest on reserves to direct short-term rates.
The Fed came to believe that expectations management is the essence of monetary policy. But the theory of forward guidance never made such a claim. It was theorized as an emergency tool. And now it had become the tool of monetary policy and the Fed’s primary way of looking at the world. The danger of inflation, for example, came to be seen mostly in terms of the danger of “unanchored” inflation expectations. It was expectations all the way down.
Making Normal Great Again
What Warsh is doing is not going to make the Fed less transparent. And, pace Carmel Crimmins at Reuters, it isn’t really about giving “central bankers more flexibility.” Forward guidance was not born as a transparency initiative or a volatility suppressant. It was a stimulus tool for the zero lower bound. The sweeping changes Warsh is planning should be seen as an effort to move the Fed out of the financial-crisis rut and back onto the main path of monetary policy.
As Warsh said in a speech last year, “forward guidance—a tool rolled out to great fanfare in the financial crisis—has little role to play in normal times. Moving markets with rolling Fed incantations is tempting, but unhelpful to the Fed’s deliberations, and ultimately, to its mission.”