Kevin Warsh came to the Federal Reserve as an agent of change and quickly launched five teams to review areas such as the Fed’s communication and balance sheet and inflation frameworks—topics that deserve a fresh approach. He doesn’t have time to wait for their conclusions.

Warsh’s deliberate ambiguity on monetary policy isn’t sitting well with investors and the policy committee’s slow response to inflation amid a series of supply shocks is deepening a credibility problem with financial markets and the broader public.

Warsh’s communication at the July press conference after the two-day policy meeting was widely panned by investors and economists. Those criticisms weren’t only about style or his reluctance to comment on the economic and policy outlook. The real complaint: bond investors don’t understand how his repeated pledge to restore stable prices squares with inaction on interest rates. Short-term rates fell notably by the time the press conference was over, but long-dated Treasuries sold off, pushing yields up to 5.2 percent, the highest since 2007.

This can be costly. The rise in long-term bond yields raises borrowing rates for the U.S. Treasury and home buyers, while persistent inflation continues to rob ordinary Americans of day-to-day purchasing power.

One way to evaluate the Fed is by measuring it against its own principles for policy conduct.

1. Monetary policy needs to be well understood by the public and systematic.

In response to a question at the July press conference, Warsh described the Fed as “in the performance business.’’ The performance on communication has been mixed so far. There are 19 participants at the Federal Open Market Committee meeting. Many explain how their policy views are evolving with the incoming data and risks.

Dallas Fed president Lorie Logan, who dissented in favor of a quarter-point hike at the July meeting, gave a detailed explanation of her analysis and concluded that price increases are likely to settle somewhere between 2 percent and 3 percent.  “We should not perpetually achieve one goal while missing the other,’’ Logan said in July 16 remarks. “Modestly higher interest rates would better balance the outlook and risks.’’

And, remaining consistent with her views, that is how she voted.

When pressed on why the Fed held rates steady, Warsh said: “We’re going to deliver on the responsibility that Congress gave us, and today’s meeting, and the preparation for today’s meeting, was an important step towards that destination.’’

That didn’t communicate a systematic or understandable approach to monetary policy. Omitting detailed forward guidance may be appropriate in a non-crisis environment where inflation is elevated and interest rates can be raised or cut as needed. But the Fed remains an important player in how interest rates are set. When the Fed holds steady during persistent inflation and fails to provide a convincing explanation, investors respond by pushing yields higher to compensate for inflation risk. It’s that simple.

2. Central banks should stimulate when the economy is operating below potential and inflation is below goal and restrict when the economy is overheating and inflation is too high.

This seems simple enough but measuring the economy’s potential output in real time is difficult, especially now, with the economy hit by a number of shocks in the past several years. An encouraging component of Warsh’s press conference was his description of how policy makers are looking hard at how the shocks will impact economic growth and prices and what tools they have to respond. He mentioned the pandemic, military conflicts, energy disruptions, tariffs, and the surge in investment related to artificial intelligence.

These are important avenues of discussion and research. But he didn’t tie any of these observations into near-term action, and it seems clear that tariffs, wars and the AI boom are all making some contribution to persistent inflation at this point.

3. The Fed should raise or lower the policy rate by more than one-for-one in response to a persistent increase or decrease in inflation, respectively.

In a textbook example of this principle, the Fed hiked interest rates more than five percentage points over 2022 and 2023 in response to rising inflation. The real yield on 2-year Treasury Inflation-Protected Securities (TIPS) jumped from about negative 3 percent to a peak of 3 percent by the second half of 2023. 

The combination of cuts since 2024 and inflation rising again on the back of high energy costs due to the Iran conflict has left short-term real rates low. For example, subtracting the New York Fed’s measure of one-year ahead household inflation expectations of about 3.7 percent from the federal funds rate produces a real interest rate of about zero and slightly more than a half percentage point on the one-year Treasury bill. The Fed never finished the job of taming high, sticky inflation. Low real rates won’t do the trick.

So far, market-based measures of long-term inflation expectations have remained anchored. But investors appear to condition the return of inflation to the 2 percent target to tighter monetary policy. If the Fed won’t deliver on policy, its credibility will suffer and markets will question its resolve to enforce price stability. We have seen a simple preview of this in the time window between the release of the statement and the end of the press conference after the July FOMC meeting.

If Chairman Warsh wants markets to do some of the heavy lifting, pushing rates higher to tackle inflationary pressures, he must clarify how the Fed will react to incoming data—even without providing guidance on what the next move of federal funds rate will be.

Lastly, the stance of monetary policy should be judged not simply by the level of real rates. What ultimately matters for households and firms are overall financial conditions, and they’re stimulative. Dallas Fed president Logan mentioned this in a statement explaining her dissent.

Stock valuations are still high despite recent price declines and a Bloomberg measure of high-risk, high-yield bond spreads is nearly a point below its 10-year average. Tightening financial conditions through ambiguous communication and unexplained policy inertia that causes an overshoot in long-term bond yields is a high-cost strategy.

---

A version of this blog first appeared on MarketWatch.