The Fed’s Kevin Warsh Is Already on the Right Track

I am normally not a fan of a task forces. They often waste time and resources, even when they produce some good ideas. But last month, just before Kevin Warsh’s first press conference as Chair of the Federal Reserve, I was asked what he should put on his list of priorities. My first thought was that he should gather the best experts on the Fed’s balance sheet and figure out how to tame that beast.

That’s exactly what he plans to do. During that press conference, Warsh announced task forces to revise communications, balance sheet policy, data use and method, and the inflation framework. He clearly has ambitions for a new era in monetary policy.

The new era is really a return to the old way of the pre-Ben Bernanke Fed. That old way was characterized by less transparency, less precommitment, and fewer extraordinary policies. The late twentieth-century monetary policy, most closely associated with Alan Greenspan, is exactly what the Fed needs in order to manage the challenges ahead. But going back to it will be difficult; Warsh will need lots of expert help.

Former chair Jay Powell ended his term amid heaps of praise. He managed to reduce inflation without bringing on a recession and stood up to President Donald Trump’s political attacks.

But his regime was not without errors, and these missteps ought to induce a monetary policy rethink. A long period of low rates, low inflation, and low unemployment preceded the 2019 framework review, in which the scope of monetary policy was reassessed. As a result, the Fed decided to put more weight on unemployment because inflation seemed to be a problem solved, while some groups still had higher rates of nonemployment.

With interest rates near zero, the Fed felt it had limited means to influence the economy. So Powell also recommitted to Forward Guidance (which involves telling markets the likely direction of future policy) by being more transparent and open about the central bank’s intentions. At the time, Forward Guidance was in fashion because it was assumed that it could be just as powerful for the Fed to say that it was doing something as to do it. Powell also continued usage of the dot plot, which revealed committee members’ expectations for future rates and other macro variables, offering the market even more transparency.

Then the pandemic hit. To avoid a major economic meltdown, Powell cut interest rates to zero and reinstated Quantitative Easing—the direct purchase of Treasury assets by the Fed to stimulate the economy—on a much larger scale than ever before. He also committed to keeping rates low until the labor market recovered.

Much of this turned out to be a mistake. Even as inflation returned, the Fed kept rates at zero and kept buying long-dated assets. That happened in part because the Fed committed to low rates as part of Forward Guidance; the central bank said that it would tolerate periods of above-target inflation until the economy reached maximum employment.

Members of the Fed Board also revealed in their dot plots that they expected inflation to be short-lived. But month after month, the data did not match the forecasts. The Fed Board is evidently just as bad at predicting the future as everyone else.

Perhaps worst of all, the Fed’s larger balance sheet became a liability. Buying long-term bonds with short-term borrowed funds lost money for taxpayers when long-term interest rates rose with inflation. The sheer scale of mortgage-security buying continues to distort the housing market.

Warsh hopes to undo many of the policies that contributed to these mistakes. He claims to be rethinking Forward Guidance, and he declined to participate in the dot plot.

These are wise moves. Both policies were supposed to provide transparency and better monetary policy. In practice they boxed the Fed into approaches that were harmful or unattainable.

The Fed is only as effective as it is credible. Forward Guidance that can’t be followed, or a forecast that always proves wrong, only worsens credibility and weakens monetary policy. Talking less is an easy fix.

The bigger challenge will be shrinking the Fed’s balance sheet, which reached nearly $9 trillion at its peak. One problem has been that paying interest on the reserves financing Quantitative Easing has meant that few banks lend to each other to meet their reserve requirements. Between the higher rates on reserves and post-financial crisis liquidity requirements, banks have an incentive to maintain high reserves at the Fed, as needing a loan from another bank signals weakness. The lack of lending and higher reserves reduce liquidity in the market unless the Fed keeps buying assets—forcing the balance sheet to keep growing.

Stanford finance professor Darell Duffie, who was my first fantasy pick for a Fed task force, has some ideas on what the central bank can do to reduce the size of the balance sheet:

First, the Fed could revise its liquidity regulations so that banks feel less pressured to conserve their reserve balances. Second, it could change the operations of Fedwire (the Fed’s largest payment system) so that banks could make their outgoing payments with incoming payments and thus need fewer reserves at the start of each day. Third, the Fed could tier interest rates on reserves, paying a lower interest rate on reserve balances beyond a specified target or quota, thus giving banks a strong incentive to lend these extra balances. And, fourth, the Fed could smooth the path of reserves by offsetting unintended shocks to the supply of reserve balances, for example those that occur at the end of each quarter.

Post-financial crisis monetary policy was an important experiment inspired by leading research in monetary policy. Its principles were transparency, communication, and aggressive action when there was a problem. Perhaps these were the right policies when rates were near zero and below-target inflation was the biggest concern. But the last six years exposed the limitations of this framework.

We are in a new economy, one in which financial conditions require an older framework. The Fed must be humbler about what it knows, what it can achieve, and how much of a presence it should have in financial markets. This humility may ultimately make the Fed more powerful.