At its most recent meeting, the Federal Reserve held rates constant, as most investors were expecting. Prior to the meeting, which resulted in a split 9–3 vote, there were rumblings of discontent among members of the Federal Open Market Committee (FOMC), mostly over Chairman Warsh’s controversial views on inflation, interest rates, and the Fed’s balance sheet.
What do we know about Warsh’s views? In a 2018 paper, he argued that “the central bank and the academic community should engage in a fundamental rethinking of the Fed’s strategy, tools, governance, and communications.” In this article, I discuss three points made by Warsh as well as the evidence from economic research.
The Tyranny of Forward Guidance
Fed officials try to make their future plans clear to the public, a policy known as forward guidance. Setting the public’s expectations can, at least in theory, improve the efficiency of monetary policy. One problem, however, is that the more specific Fed officials are about their plans, the harder it is to change them.
This was a major problem in the post-pandemic period. Chair Powell promised “ample warning” before any changes in policy, but when it became clear in late 2021 that loose monetary policy was driving the highest inflation in 40 years, Powell was reluctant to change course. His failure to act made inflation worse, which eroded the value of the dollar and reduced the real incomes of average Americans.
To prevent the lock-in effect of forward guidance, Warsh has argued that the Federal Open Market Committee (FOMC) should have a long-term strategy that is not altered by fluctuations in short-run economic conditions. “It would scarcely require Fed speakers to rush to update their guidance to market participants,” allowing them the flexibility to adopt the best policy in the face of a changing economy.
“The most common forecasting error is groupthink.”
Federal Reserve Chairman Kevin Walsh
Groupthink at the Fed
The FOMC relies on discussion and debate to formulate its monetary policy decisions. At each meeting, the members share their opinions about the state of the economy and are briefed by Fed staff economists who share their economic forecasts. According to Warsh, however, the staff presentations may lead to excessive conformity among FOMC members. “The most common forecasting error,” he says, “is groupthink.”
“There is a tendency to try to find an anchor,” Warsh describes, “and FRB/US — the dynamic, stochastic, general equilibrium model that has served at the core of the Fed’s thinking for decades — ends up being the leading device through which a lot of discussions are conducted in formulating policy.”
The problem of groupthink is evident from the FOMC’s Summary of Economic Projections. Four times per year, the FOMC members publish projections of what they expect in the coming years for the rates of inflation, unemployment, and GDP growth. Despite some recent dissent, Warsh rightly notes that their projections have historically tightly converged on the economic forecasts presented by the Fed staff. “The dot forecasts from members of the FOMC are nearly on top of one another.”
Indeed, groupthink has become a serious problem at the FOMC. Research confirms that the projections by FOMC members conform closely to the forecasts of the FRB/US model. The lack of intellectual diversity has likely led to suboptimal monetary policy decisions. In addition, the FOMC’s forecasts have been very wrong, which may also have led to policy mistakes.
Rethinking the Fed’s Tools
Warsh wants to reconsider the Fed’s use of its monetary policy tools, especially its large balance sheet. The payment of interest on reserves that banks hold at the Fed and the rate on overnight reverse repurchase agreements have caused the Fed’s total assets to explode from less than $900 billion in 2007 to almost $9 trillion in 2022, which Warsh notes is “markedly different than projected” when this policy was first proposed.
Warsh has argued that the Fed’s “bloated” balance sheet gives it an outsized footprint in financial markets, which inhibits financial intermediation and distorts market prices. “We should not encourage the financial markets to be the handmaiden of the central bank,” he said. “We should allow asset prices to be an independent source of economic insight and discipline.”
Overall, Warsh seems correct on all three points. It is refreshing to see a Fed Chairman take an objective look not only at Fed policy but at the institutional arrangements that hinder good policy decisions. Warsh’s criticisms are fair and supported by evidence from economic research. Now, we will see if those insights will translate to better policy.