The heat at Jackson Hole Fed meeting - not innovation but inflation

 

The Jackson Hole economic summit has an agenda set in advance, though it is released at the beginning of the conference. The conference agenda focuses on innovation and features some top-flight speakers. The agenda will be interesting, but the real talks will be in private or in the Q&A between the economists. Several Fed officials have spoken out on inflation; however, the audience will want to hear whether Chairman Warsh will clarify his policy thinking.

We will hear at 10 AM EST today.

Fed balance sheet - More work to do

The issue that has been important to Fed Chairman Warsh has been the Fed balance sheet. There still isn't enough focus on the dynamics of changes in the balance sheet, inflation, and credit. Total Fed assets are still more than 6 times higher than before the Great Financial Crisis, which was well over 15 years ago. Now, Fed regulatory rules have changed, so the total assets may be much higher for a normal state, but what is the proper number is still. not clear. We do know that over $8 trillion is too high, and more than 25% of GDP is also too high; yet, given inflation is still above target, we should see the balance sheet reduced further. The RMP program is going to zero, which will take out the small blip in 2026, but there is more work. Mortgages will roll off slowly given the low prepayment rates, but that is only a small portion, and the Fed is currently buying bills with the cash flow. There is reluctance to sell Treasuries given the Treasury's strong financing needs. 

To solve the inflation issue, the Fed will need to further reduce its balance sheet.  

 

Monetary policy uncertainty relatively stable

Everyone in the bond markets has been talking about Fed Chair Warsh and his changing views on forward guidance. His policy stance is clear. He does not want to give forward guidance. He will reduce guidance to the minimum. Markets have reacted to this with much wailing, yet we need to focus on the actual impact on markets. One way to look at this is through market-based measures of monetary policy uncertainty. We have a history through an index created by the San Francisco Fed. The data suggests there was a spike when Chairman Warsh was appointed but has been relatively stable for the last few months. Overall, the Warsh regime is showing higher uncertainty, but the levels are not at extremes. Nevertheless, there should be concern not for the short run but for numbers that are closer to 24 months. Longer-term uncertainty is always higher than shorter forecasts; however, there needs to be focus on what investors are thinking beyond 2026. 

 

The failure of forward guidance or what should we expect

 

Analysts are calling it a failure of the Fed's new forward guidance policy. The policy, of course, is no forward guidance. Given Fed Chairman Warsh is not going to tell the market much about the intention of Fed policy other than "it will not waver" from trying to fight inflation, the market will have to decide on the efficacy of current policy. The Fed, instead of driving policy, can now learn what the markets are discounting. The market is now providing information to the Fed instead of the Fed trying to manipulate the direction of rates. 

Prices and markets are acting as signals, not as something that is controlled by central bank guidance. Now, the Fed and the market may not like the signal,  but they are signals nevertheless. The signals are now very clear. The market does not believe that the Fed can control inflation, especially over the longer run. Long rates are reaching year highs, and the yield curve is steepening. This signal, especially with the increase in real rates, is tightening the credit markets. 

The bond markets are now once again a signaling market. There will be more uncertainty in these markets, but they are now telling the Fed what they think about policy, both monetary and fiscal. You may not like what the markets is telling us, but the message is clear.

Warsh and the star-studded task forces

 

Chairman Warsh has announced the members of his task forces for review of Fed policies. I am impressed by the choices and the seriousness with which you are trying to provide fresh perspectives on some key problems. This is not an internal review but includes both business and academic thinkers with key knowledge for each task. I am thinking this may be one of the most extensive and far-reaching reviews ever attempted by the Fed. 

Task Force	Objective / Focus Area	Members (Co-Leaders)
Communications	Reviewing how the Federal Reserve conveys policy deliberations, decisions, forward guidance, and economic projections.	* Peter R. Fisher (Professor of Practice, Foster School of Business, University of Washington)* Arminio Fraga (Founder/Chairman, Gávea Investimentos; former President, Central Bank of Brazil)* Mervyn King (Former Governor, Bank of England)
Balance Sheet Policy	Examining the costs, benefits, and institutional implications of the Fed’s balance sheet regime.	* Karen Dynan (Professor of Economics, Harvard University)* Raghuram Rajan (Professor of Finance, University of Chicago Booth; former Governor, Reserve Bank of India)* Jeremy Stein (Professor of Economics, Harvard University; former Federal Reserve Governor)
Data	Improving the quality, speed, and timeliness of real economic signals to inform monetary policy decisions.	* Raj Chetty (Professor of Economics, Harvard University)* Doug McMillon (Former President and CEO, Walmart Inc.)* Kevin Murphy (Professor of Economics, University of Chicago)
Productivity and Jobs	Assessing the economic impact of general-purpose technologies, particularly artificial intelligence (AI), on labor and productivity.	* Marc Andreessen (Cofounder and General Partner, Andreessen Horowitz)* Charles I. Jones (Professor of Economics, Stanford University / Anthropic)* Asha Sharma (Executive Vice President & Xbox CEO, Microsoft Corp.)
Inflation Frameworks	Evaluating the effectiveness and design of the Federal Reserve’s framework for price stability and inflation targeting.	* Greg Mankiw (Professor of Economics, Harvard University; former Chair, Council of Economic Advisers)* Thomas Sargent (Professor of Economics, NYU; Nobel Laureate)* William White (Senior Fellow, C.D. Howe Institute; former Economic Adviser, BIS)

Warsh and forward guidance - NOT

 

What is clear from the first Warsh press conference is that he will not provide forward guidance on the Fed’s actions. Chairman Warsh is not going to tell the market anything about what the Fed may be doing in the immediate future.

Governor Waller, on the other hand, provided a spirited defense of forward guidance that serves a specific purpose, albeit flexible to meet policy needs. Perhaps forward guidance was useful when we were close to the zero bound, and the Fed wanted markets to know that rates would be lower for longer. It may not be appropriate today, given that we are in a different regime.

Nevertheless, forward guidance is supposed to signal policy to the makrets os they will bend to the desires of the Fed. If the Fed is unsure which direction to take, any forward guidance may be wrong-footed. 

In any case, less forward guidance should lead to more bond market volatility and more discussion on what the Fed is thinking. Fed watch is back in vogue.

Hidden Dissent and the Fed

 

The markets were in an uproar over the dissents at the last FOMC meeting, and they may be expecting further dissent at the July meeting. Yes, dissent announces and measures dissent, but there are other ways to measure dissent that may be more useful. Researchers can look at the comments of Fed governors and bank presidents to measure dissent. The use of NLP and LLMs can count words, form sentiment indices, and use context to measure differences of opinion over time. 

Two researchers have examined transcripts and minutes from Fed officials to measure what they call “hidden dissent.” Their index is available through their website, digitecon.org. Their index correlates with dispersion in SEP forecasts. Markets respond to dissent across the Fed.  

Data dependence as "constrained discretion"

Ben Bernanke and Rick Mishkin called the use of data dependence in monetary policy "constrained discretion". We are in another of those periods of constrained discretion regarding inflation and monetary policy. 

Robert Hetzel, a former Fed economist, said that policymaking has a flavor of "guess and correct." There are forecasts and guesses of what should be the key target variables, inflation and growth, and then policy is corrected to move toward the target. 

The data dependence is an important part of the guess-and-correct view. There is no set rule, but a set of adjustments toward the expected target. 

The end of forward guidance - Good, let's use rules

 

Recent comments from Fed Chairman Warsh suggest that he is not in favor of the current forms of forward guidance. No dot plots, or perhaps not in the current form. The Fed has proven to be a poor forecaster, so the guidance may not be helping the market. It does not make sense for Fed governors and presidents to give speeches on their views of the economy when most are wrong. Let’s not have the market hanging on guidance that may be wrong. 

I have always been in favor of having a more rules-based approach that provided clarity on the general direction of policy. Can there be deviations from the rules? Yes, but there have to be good reasons that are infrequent. Of course, many governors and presidents like to give speeches, so there has to be a change in the messages to the market.

Warsh politics starts inside the Fed

 

The most important political issue for Fed Chairman Warsh is not working with Congress or keeping President Trump happy, but working on the politics within the Fed. While not like the Volcker period, the current problem is the uptick in no (dissents) to yes votes during the last year of the Powell era. While dissent does not make the Fed ineffective, it creates more market uncertainty. A high dissent ratio indicates disagreement over policy direction, which will spill over into market thinking. Is consensus necessary? No, but it is helpful, especially if there is a change in policy direction.

The politics of the Fed run through Congress

 

This is an interesting chart on the politics of the Fed. Clearly, Powell is a political animal. There is nothing wrong with being political. It is important to maintain good communication with politicians to ensure they understand the Fed's role and mission. One of the key Fed battles has always been the level of oversight from Congress. (I was involved in that fight in the 1980's when consulting for the GAO on primary dealer oversight. Getting data from the Fed was an ordeal.)

Powell needs to limit interference from the executive branch and ensure there is limited oversight from Congress. Independence takes work. 

Fed Up - a reread on the politics of the Fed

 

Is the Fed political? Yes, to the extent that it is driven by its own self-interest and preservation. It is political in that there is significant inbreeding of thinking and culture. This is especially true of research. All well-trained economists who often think alike and are focused on publishing research on their chosen topics, rather than on driving better decision-making by the Fed. It is not that they do not want good policy. It is the fact that they cannot think of how to do policy that veers from the status quo. One could say that QE and zero-interest rates did not establish the status quo, but they were a solution that fit the macroeconomic narrative at the time. 

I reread the Book Fed Up to hear one insider’s view of the Fed. This is not written by the Chairman or a leading economist but by a Fed bank advisor. It was a little long and could have been more directed in its arguments. Still, anyone who reads this will appreciate that having well over 1,000 economists and multiple regional district banks is crazy and does not serve the country’s good or its policies. 

I am not arguing for lower rates, but I will argue that the Fed could use a good shake-up. 

Putting Fed dissent in perspective

 

Whenever there is dissent with Fed votes, there is an uproar by market analysts who are trying to make sense of why someone would have a different opinion. Indeed, dissents have increased, but the absence of dissents was unusual during the Powell period. If you look at other periods, the number of dissenting votes was greater and more often. Greenspan was the exception with few dissents, but that was only later in his tenure as Chairman. During the Volcker period, one could say the Fed was in revolt. 

The lack of consensus is beneficial. Yes, it creates uncertainty, but it also tells us there is honest debate.

Fiscal versus moentary dominance - the real battle

Janet Yellen, who served as both Treasury Secretary and Fed chairman, presented "The Future of the Fed: Central Bank Independence and Fiscal Dominance" at the AEA convention earlier this month. She does a thoughtful job of describing the differences between these two forms of dominance, yet she misses the mark in her description of the current environment.

We cannot continue independence and monetary dominance if there is a fiscal crisis. Fiscal policy saw periods of deficit and then a return to something normal; however, in the last decade, or since the Great Financial Crisis, there has been a change in government debt dynamics, so that fiscal policy has a more dominant role in monetary policy. Dominant does not mean controlling. In this example, fiscal dominance means the issues with fiscal policy have a more dramatic impact on the economy than monetary policy.

The current debt levels cannot be sustained with a growing amount of tax revenue used to pay interest on debt. The Fed has ignored this fiscal crisis. They have refused to comment on rising debt-to-GDP ratios to avoid being political. Yet the ongoing QE process, coupled with Fed high Treasury balances, shows that the Fed has lost its monetary dominance and must deal with a debt crisis. 

Trump's desire to lower interest rates is just an extreme manifestation of the fiscal dominance needed to sustain current government policy. Let's not forget that inflation is one way of getting out of a fiscal bind. If there were controlled deficits, there would not be a need to discuss lower interest rates. The fiscal excesses of the past have to be addressed. Yet, who wants to say we have a debt problem?  

Important paper on the Fed operating target from Lorie Logan, Dallas Fed President

 

Lorie Logan, the president of the Dallas Fed, gave an important speech called "The case for modernizing the FOMC’s operating target rate". I recommend it for anyone studying monetary policy and focusing on fixed income. It does not offer an immediate insight that generates wealth, but it provides a valuable glimpse into how the Fed may be considering new target rates and implementing policy. 

First, President Logan provides a good history of how the Fed's operating targets have changed over the last few decades. The Fed adjusts in response to structural changes in the market and the goals of the FOMC. Second, it explains why the current operating target is flawed, and third, it offers some solutions that can be implemented to make Fed policymaking more effective. Nothing is likely to happen in the short run, but this speech does provide insights into what changes may be coming down the road. 

Simply put, the current targeting of Fed funds is outdated because the current period of the Fed providing ample reserves means there is not a strong demand for borrowing and lending Fed funds. The market has shrunk with foreign banks being the primary borrowers, and FHLB banks serve as the chief lenders. The trading is a fraction of its former self. 

The key short-term rates are SOFR, which serves as a substitute for LIBOR, and tri-party repo, a deep and liquid market associated with borrowing and lending using Treasury collateral. One operating target is most effective, and Logan suggests a repo target may best serve the market. 

At some level, this may not change the overall mechanics of the short-term credit market, but it will provide a more effective signal and be a better representative of where short-term credit is trading.  

The uncertainty of monetary policy - from internal to external

 

There is considerable discussion about the uncertainty surrounding Fed monetary policy; however, it is essential to break down that uncertainty into two key components: internal and external. Internal uncertainty is associated with policymakers not having a consensus on the direction of policy. External uncertainty is related to the lack of agreement among market participants or how investors perceive the direction of monetary policy. 

Generally, the market focuses on external uncertainty. Internal uncertainty is minimized by the Fed, usually voting in agreement at the Fed meeting. We may learn about disagreement with a long lag. However, we can use the SEP forecasts as a proxy for internal conflict. If the path of the SEP forecasts shows little dispute, then there is little uncertainty. If the SEP forecasts are diverse, then there is little agreement on inflation or growth. You cannot have agreement on policy action if the forecasts for interest rate directions are all over the dot plot. 

Currently, we are seeing significant divergences between these forecasts. You cannot have an agreement with the policy if you have some Fed SEP showing wide differences. This is clearly the case for 2025 and the following years. Investors cannot be expected to make firm investment plans if they cannot see agreement among the central bankers.

The quantity theory of money still exists

 

Tim Congdon authored a new book, The Quantity Theory of Money: A New Restatement, last year. It is a historical retrospective of the classic quantity theory of money with some new twists. It is not a easy book for those who are not familiar with the long history of money. It takes a number of twists and turns on why some explanation do not work, but in the end, Congdon again emphasizes that money is at the heart of any discussion of inflation. 

The key insight is that money will impact not just the bond market which is the traditional view in the classic IS-LM modei but will also affect othe asset markets and goods markets. Money seeps into everything we do. We have to also focus on broad money, and how it affects asset purchases and goods purchase decisions. The link between money and credit is a better description of how it impacts transactions nd prices than the simple Friedman money multiplier.  

The inflation post-COVID should not have been a surprise for anyone who follows the money trail.

The Fed always to the rescue?

There has been considerable discussion about the need for the Fed to lower interest rates. I do not want to get involved in that battle at this time. Instead, I have been shocked by the chart below concerning the "lender of last resort" Fed behavior. The numbers are outstanding. We thought that the Fed was active during the GFC; yet, if we look at the post-2020 period, we will see the Fed going to almost any length to support stability. The COVID response was overkill, but the First Republic response was on a different level. This may be internalized in the minds of investors, yet we cannot know with certainty what the Fed will do next time. There is moral hazard uncertainty, and this can be a problem. 

 from @greg_martis 

The impact of narrative: The power of Fed speak

 

We expect that the Fed speeches have an impact; however, the measure of their effect on equity and bonds has not been precise. A paper, "Mind your language: Market responses to central bank speeches," shows that from the speeches, there are forecast revisions that can then explain volatility and tail risk in major asset  classes. Fed chairman speeches will have more impact than others through larger forecast revisions, but the Fed chairman can also calm markets with the right speech. 

The paper utilizes NLP, or natural language processing, to aid in identifying information that causes changes in macroeconomic forecasts. The critical point is analyzing the continuous flow of central bank communication, not just an isolated speech. There are clear regimes in Fed speak, and it is good to identify these trends. 

Quants focus on what is countable, yet the non-countable, like we see in speeches, is essential. If you can turn the non-countable from narrative into something measurable, there is an opportunity to form probabilities and make better trades.

I have taken the view that you want to avoid FOMC and major Fed speeches because there is too much uncertainty; however, if we decompose what is said, investors may be able to tilt their positions to their advantage. 

The Fed - there is no dissent and that is not good

Jim Bianco generated this interesting chart about the Fed and Chairman Powell. He discussed the power vested in the Fed chairman and whether firing him would be good or bad. His argument is that if Chairman Powell were fired, it would be good for the Fed because there would likely be more dissent from the other FOMC voting members. This argument is a little weird. Creating a crisis with the Fed Chairman would create more chaos, and that would be good for markets and policy. 

I don't buy it, but the core issue is the amount of dissent at the Fed. I think of the old phrase, "If everyone is thinking the same, then someone is not thinking".  Why have an FOMC committee if the goal is to have unanimous voting? Granted, this often happens with boards, yet as a public institution with different district banks, it is hard to believe that everyone is or should be in agreement. More dissent will create uncertainty, but if the goal is uniformity, then let's cut the regional bank model and have a small board.