Under Warsh, the Fed Has Failed to Uphold the Principles of Good Monetary Policy
Bond investors do not understand how Federal Reserve Chair Kevin Warsh's pledge to restore price stability can coexist with inaction on interest-rate policy. Warsh came to the Fed as an advocate for change and quickly launched five teams to review areas including the central bank's communications, balance sheet and inflation framework—subjects that do require a fresh approach. But he did not have time to wait for those teams' conclusions before taking action to contain inflation. Warsh's deliberate ambiguity on monetary policy has not been well received by investors. Amid a series of supply shocks, the policy committee's slow response to inflation is deepening the Fed's credibility problems in financial markets and among the public. After a two-day policy meeting that ended with a decision to leave interest rates unchanged, Warsh's communication at the July news conference drew widespread criticism from investors and economists. The criticism was not merely about style or his unwillingness to comment on the economic and policy outlook. The central complaint was that bond investors did not understand how his repeated pledge to restore price stability could coexist with inaction on interest rates. By the end of the news conference, short-term rates had fallen significantly, while long-term Treasurys were sold off, pushing the 30-year Treasury yield to 5.2%, its highest level since 2007. That could prove costly. Rising long-term bond yields increase borrowing costs for the U.S. Treasury and homebuyers, while persistent inflation continues to erode the everyday purchasing power of ordinary Americans. One way to assess Warsh's leadership of the Fed is to examine whether the central bank is following its own "key principles of good monetary policy." So far, it has not met that standard. Monetary policy needs to be well understood by the public and systematic. Answering a question at the July news conference, Warsh said the Fed is "in the performance business." So far, its communication has been mixed. The Federal Open Market Committee has 19 participants, and many have explained how their policy views evolve as new data and risks emerge. Dallas Fed President Lorie Logan voted at the July meeting to raise rates by 25 basis points. She explained her analysis in detail and concluded that price growth could settle between 2% and 3%. "We should not succeed forever at achieving one goal while missing another," Logan said in a July 16 speech, referring to stable low unemployment and inflation. "A modestly higher interest rate would better balance the outlook and risks." Consistent with that view, she voted accordingly. When asked why the Fed had left rates unchanged, Warsh said: "We will fulfill the responsibilities Congress has given us, and today's meeting, as well as the preparation for today's meeting, is an important step toward that goal." That did not convey a systematic or understandable approach to monetary policy. In a noncrisis environment with high inflation, where rates can be raised or lowered as needed, it may be appropriate to omit detailed forward guidance. But the Fed remains an important participant in setting interest rates and should provide some information about how officials reached their conclusions. When the Fed leaves rates unchanged during persistent inflation without offering a convincing explanation, investors respond by pushing yields higher to compensate for inflation risk. It is that simple. When the economy is operating below potential and inflation is below target, a central bank should stimulate the economy. When the economy is overheating and inflation is too high, it should tighten policy. That sounds simple enough, but measuring the U.S. economy's potential output in real time is difficult—especially after the economy has been hit by multiple shocks in recent years. One encouraging aspect of Warsh's news conference was his description of how policymakers are studying the effects of those shocks on economic growth and prices, as well as the tools available to respond. He mentioned the pandemic, military conflicts, energy disruptions, tariffs and a surge in investment related to artificial intelligence. These are important subjects for discussion and research. But Warsh did not connect any of those observations to near-term action, and for now, tariffs, war and the AI boom all appear to be contributing to persistent inflation to some extent. The Fed should raise or lower its policy rate by more than one-for-one in response to a sustained rise or fall in inflation. In a textbook example of that principle, the Fed raised rates by more than 5 percentage points in 2022 and 2023 in response to rising inflation. The real yield on two-year Treasury inflation-protected securities rose from about negative 3% to a peak of 3% in the second half of 2023. Rate cuts since 2024, combined with inflation rising again as energy costs increased because of the conflict involving Iran, have left short-term real interest rates low. For example, subtracting the New York Fed's measure of one-year household inflation expectations—about 3.7%—from the federal funds rate produces a real rate of about zero. The real rate on a one-year Treasury bill is slightly above half a percentage point. The Fed has never completed the task of containing high and sticky inflation. Low real interest rates cannot solve the problem. So far, market-based measures of long-term inflation expectations remain anchored. But investors appear to be conditioning a return of inflation to the 2% target on tighter monetary policy. If the Fed does not act, its credibility will suffer, and markets will question its determination to deliver price stability. A simple preview of that dynamic emerged in the window between the release of the statement after the July FOMC meeting and the end of the news conference. If Warsh wants markets to shoulder part of the burden by pushing rates higher to counter inflationary pressure without Fed action, he must explain how the Fed will respond to forthcoming data. He may be able to do that without providing guidance on the next move in the federal funds rate. Finally, the stance of monetary policy should not be judged solely by the level of real interest rates. What ultimately matters to households and businesses is overall financial conditions, and those conditions are currently stimulative. Dallas Fed President Logan made that point in the statement explaining her dissent. Despite a recent decline in stock prices, equity valuations remain high. A Bloomberg measure of spreads on high-risk, high-yield bonds is nearly 1 percentage point below its 10-year average. Tightening financial conditions through vague communication and unexplained policy inertia—which has pushed long-term bond yields excessively higher—is a costly strategy.
Warsh came to the Fed as an advocate for change and quickly launched five teams to review areas including the central bank's communications, balance sheet and inflation framework—subjects that do require a fresh approach. But he did not have time to wait for those teams' conclusions before taking action to contain inflation.
Warsh's deliberate ambiguity on monetary policy has not been well received by investors. Amid a series of supply shocks, the policy committee's slow response to inflation is deepening the Fed's credibility problems in financial markets and among the public.
After a two-day policy meeting that ended with a decision to leave interest rates unchanged, Warsh's communication at the July news conference drew widespread criticism from investors and economists. The criticism was not merely about style or his unwillingness to comment on the economic and policy outlook. The central complaint was that bond investors did not understand how his repeated pledge to restore price stability could coexist with inaction on interest rates.
By the end of the news conference, short-term rates had fallen significantly, while long-term Treasurys were sold off, pushing the 30-year Treasury yield to 5.2%, its highest level since 2007.
That could prove costly. Rising long-term bond yields increase borrowing costs for the U.S. Treasury and homebuyers, while persistent inflation continues to erode the everyday purchasing power of ordinary Americans.
One way to assess Warsh's leadership of the Fed is to examine whether the central bank is following its own "key principles of good monetary policy." So far, it has not met that standard.
Monetary policy needs to be well understood by the public and systematic.
Answering a question at the July news conference, Warsh said the Fed is "in the performance business." So far, its communication has been mixed. The Federal Open Market Committee has 19 participants, and many have explained how their policy views evolve as new data and risks emerge.
Dallas Fed President Lorie Logan voted at the July meeting to raise rates by 25 basis points. She explained her analysis in detail and concluded that price growth could settle between 2% and 3%. "We should not succeed forever at achieving one goal while missing another," Logan said in a July 16 speech, referring to stable low unemployment and inflation. "A modestly higher interest rate would better balance the outlook and risks."
Consistent with that view, she voted accordingly.
When asked why the Fed had left rates unchanged, Warsh said: "We will fulfill the responsibilities Congress has given us, and today's meeting, as well as the preparation for today's meeting, is an important step toward that goal."
That did not convey a systematic or understandable approach to monetary policy. In a noncrisis environment with high inflation, where rates can be raised or lowered as needed, it may be appropriate to omit detailed forward guidance. But the Fed remains an important participant in setting interest rates and should provide some information about how officials reached their conclusions. When the Fed leaves rates unchanged during persistent inflation without offering a convincing explanation, investors respond by pushing yields higher to compensate for inflation risk. It is that simple.
When the economy is operating below potential and inflation is below target, a central bank should stimulate the economy. When the economy is overheating and inflation is too high, it should tighten policy.
That sounds simple enough, but measuring the U.S. economy's potential output in real time is difficult—especially after the economy has been hit by multiple shocks in recent years. One encouraging aspect of Warsh's news conference was his description of how policymakers are studying the effects of those shocks on economic growth and prices, as well as the tools available to respond. He mentioned the pandemic, military conflicts, energy disruptions, tariffs and a surge in investment related to artificial intelligence.
These are important subjects for discussion and research. But Warsh did not connect any of those observations to near-term action, and for now, tariffs, war and the AI boom all appear to be contributing to persistent inflation to some extent.
The Fed should raise or lower its policy rate by more than one-for-one in response to a sustained rise or fall in inflation.
In a textbook example of that principle, the Fed raised rates by more than 5 percentage points in 2022 and 2023 in response to rising inflation. The real yield on two-year Treasury inflation-protected securities rose from about negative 3% to a peak of 3% in the second half of 2023.
Rate cuts since 2024, combined with inflation rising again as energy costs increased because of the conflict involving Iran, have left short-term real interest rates low. For example, subtracting the New York Fed's measure of one-year household inflation expectations—about 3.7%—from the federal funds rate produces a real rate of about zero. The real rate on a one-year Treasury bill is slightly above half a percentage point.
The Fed has never completed the task of containing high and sticky inflation. Low real interest rates cannot solve the problem.
So far, market-based measures of long-term inflation expectations remain anchored. But investors appear to be conditioning a return of inflation to the 2% target on tighter monetary policy. If the Fed does not act, its credibility will suffer, and markets will question its determination to deliver price stability. A simple preview of that dynamic emerged in the window between the release of the statement after the July FOMC meeting and the end of the news conference.
If Warsh wants markets to shoulder part of the burden by pushing rates higher to counter inflationary pressure without Fed action, he must explain how the Fed will respond to forthcoming data. He may be able to do that without providing guidance on the next move in the federal funds rate.
Finally, the stance of monetary policy should not be judged solely by the level of real interest rates. What ultimately matters to households and businesses is overall financial conditions, and those conditions are currently stimulative. Dallas Fed President Logan made that point in the statement explaining her dissent.
Despite a recent decline in stock prices, equity valuations remain high. A Bloomberg measure of spreads on high-risk, high-yield bonds is nearly 1 percentage point below its 10-year average. Tightening financial conditions through vague communication and unexplained policy inertia—which has pushed long-term bond yields excessively higher—is a costly strategy.