Warsh Revives a Classic Approach to Central Banking

Should economic and financial actors think about where interest rates should go, or about where the Federal Reserve says they should go? Should they think about what inflation will be, or what the Federal Reserve says inflation will be? Should they consider what the Fed may do in the future with what results, or believe what the Fed says it will do in the future and what results that will have?The new chairman of the Federal Reserve, Kevin Warsh, thinks the choice in each case should be the first option, not the second. He is right. It is manifest that the members of the Federal Open Market Committee do not know where interest rates should go, or what inflation will be, or what their own actions in future times will be, or what the results of their actions will be.In all these matters, they are using estimates or making judgments — in other words, guessing, just like the rest of us. Hence the frequent inaccuracy of their forecasts and the repeated sharp surprises they experience. If the Fed leaders try to shape market actors’ expectations in line with their own expectations, which are of necessity changing and uncertain, this is in contrast with old time central bankers’ preferred opacity.The Fed chairman between 1979 and 1987, Paul Volcker, “assumed a public pose so inscrutable” that “hostile questions were deflected with rambling, evasive answers that conceded nothing.” The second-longest serving Fed chairman, Alan Greenspan , who held the office between 1987 and 2006, was likewise well known for obscure, complex commentaries that left him plenty of room for future flexibility in both views and actions. “His manner of speaking was both impressive and mysterious,” Sebastian Malaby has written. Greenspan’s most famous line in this respect is, “If I seem unduly clear to you, you must have misunderstood what I said.”The opacity strategy used a magisterial role to hide the actual lack of knowledge. Opacity, though, was challenged by the rise of the theory of “rational expectations.” As the Fed and economists considered the failures of the Fed to deliver the Keynesian dreams of economic “fine tuning” and eliminating financial cycles, they realized that part of their problem was that markets, that is, everybody else, were always anticipating what the Fed would think and do, adapting their expectations, and changing their behavior accordingly. “Rational expectations could deprive activist macroeconomic policy of any systematic real effects,” as the Federal Reserve Bank of Minneapolis explained.A corresponding shift was then, since expectations are so important, for the Fed to try to manage expectations. As economist Joe Salerno has related, Greenspan decided “to massage and mold the public’s and, particularly, the capital market’s perceptions of the Fed’s performance.”From there, on to greater transparency with Chairman Ben Bernanke, who led the Fed between 2006 and 2014, including publication of the individual forecasts or “dot plots” of Federal Open Market Committee members and “forward guidance” of what they planned to do.In time, this brought Fed assurances that interest rates would be “lower for longer,” and the Fed as Pied Piper helped induce many banks to overinvest in long-term, extremely low yielding assets. These investments led to mark-to-market losses for the banking system and in the most egregious case, the collapse of Silicon Valley Bank, with its government bailout of uninsured depositors.In short, the problem is that the dot plot forecasts and forward guidance can turn out to be wildly wrong and what the Federal Open Market Committee members were thinking was quite mistaken.As economist David Rosenberg described it, the Fed “radically swung the pendulum from opaqueness in the old days to over-transparency.” Chairman Warsh is properly turning the pendulum back again, which displays an appropriate intellectual humility in the face of an economic world of inescapable uncertainty.The former Fed opacity had a huge advantage for the central bankers themselves. It hid the fact that they did not know. With transparency, they have a corresponding big disadvantage. It makes it publicly obvious that they have no more knowledge of the future than anybody else.Thus opacity is a better strategy for central bankers than over-transparency. For the rest of us, the best strategy is to have little faith in the Fed or its paper money, and to insist on its accountability in the constitutional system of check and balances.

Warsh Revives a Classic Approach to Central Banking

Warsh Revives a Classic Approach to Central Banking

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