The most apt description of the policy framework early in Kevin Warsh’s tenure at the Federal Reserve is parsimonious.
For the uninitiated, that term is a principle that states that among competing theories or models that explain a given set of facts equally well, then the one that is preferred does so with the fewest assumptions, variables or units.
In essence, it’s an economy of choice.
And in the first policy statement of the Warsh era that is exactly what one gets.
At meetings where there is no update to the Summary of Economic Projections, the accompanying dot plot, or interest rate forecast, will be parsimonious at best.
Simplicity is rewarded. But investors, with less forward guidance to go on, end up injecting more uncertainty and volatility in the front end of the 2-year Treasury curve, which is a proxy for the federal funds rate. Today the 2-year Treasury is trading near 4.3%, well above the effective policy rate of 3.63%.
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Policy decision
When the Fed publishes its July policy decision on July 29, it will maintain its policy rate in a range between 3.5% and 3.75% and make no changes to the policy statement.
In the month since the last policy meeting, Brent crude has risen above $100 per barrel with the average cost of gasoline moving back above $4.10 a gallon.
While such an increase will engender concern among U.S. households, within the Fed’s new austere framework, it will not result in any major change to the statement.
In the press conference after the meeting, there will be questions revolving around the persistence of inflation, its drivers and the source of the supply shock.
But one should not hold one’s breath waiting for illuminating answers around inflation’s persistence other than Warsh reiterating that inflation is a choice, which is reflected in the 71% probability of a rate hike in September that the market has priced in.
While we do not expect any rate hikes this year, that sort of rapid change in expectations is what happens when the Fed moves away from forward guidance.
Partially removing forward guidance
The major change in the Fed’s approach under Warsh has been the partial removal of forward guidance from the policy statement and a far more cautious approach in addressing substantive policy questions.
Parsimony is the point. It is a feature, not a bug.
That choice favors market participants (large firms, banks, real money players, economists) with the skills to estimate the reaction function of the Fed using real-time market data and sophisticated models, and those that cannot (the public, retail investors, small and medium sized businesses).
The latter will have to continuously adjust financial management, hiring, investment and spending in the wake of market-induced volatility and unexpected policy shifts at the Fed.
Our preferred version of monetary policy focuses on financial conditions and the real economy through the shaping of expectations along the path of short-term interest rates that then shape longer-term borrowing costs.
It’s a useful method of communicating to the public, investors, and small-and medium-sized firms about the course of monetary policy so that they can make better decisions.
Forward guidance, after all, is not an unconditional promise to deliver an exact rate, say on the 10-year period; rather, it is a set of expectations conditioned on economic outcomes and not a fixed commitment.
The removal of that forward guidance results in more, not less, volatility and uncertainty around policy which during a time of rapid change carries risk for those that lack the skills, time and personnel to estimate the optimal interest rate.
Need evidence? Just look at the 2-year Treasury yield since the last Fed meeting.
The takeaway
The Fed will keep its policy rate on hold at its July meeting and make little to no meaningful changes to its parsimonious policy statement.
Warsh will use the press conference to address recent volatility in energy and commodity markets while exploring a modest acceleration in growth during the current quarter.
Expect to hear more about the unenumerated penumbras of the five new task forces at the Federal Reserve than anything about the near-term direction of policy.
In a sea of financial volatility and policy uncertainty, the one thing that investors can be certain about: The market will not be as patient with parsimony as central bank policymakers prefer.
