The velvet glove

I haven’t written a free article at Thematic Markets in over a year and this one represents a good opportunity both for public triumph and to illustrate why people who are serious about getting markets right do pay for my research. Enjoy!

Key insights

• ïYes, as predicted, Kevin Warsh is an orthodox hawk.
• ïAs importantly, he showed himself to be an extremely savvy politician who has a much higher likelihood of achieving both near-term policy credibility and long-term institutional and balance-sheet reform than I had initially considered.
• ïHe accomplished all that he needed in his first meeting: dispelled worries he was a patsy; created a clean break with the policy failures of the Powell Fed; dispensed with forward guidance; and set up near-term rate hikes.
• ïRate hikes are coming and likely will be both sooner and steeper than markets expect. The July, September and December Fed funds futures contracts remain expensive and both 2s10s Treasury curve flatteners and the dollar have room to run.

Medium as message

The impressive political acumen that Kevin Warsh displayed in his first press conference as Federal Reserve Chairman was as notable and important as the hawkish message he delivered. As I outlined in Warsh cycle, Part I, Chairman Warsh’s primary objectives for this meeting were at odds with each other: to address the acute policy failures of the Powell Fed without alienating the Committee that enacted them and that he needs both to correct near-term policy and to enact the long-term reforms he was appointed to deliver. That he delivered a terse, hawkish statement that sets up near-term rate hikes with a 12-0 vote suggests that he showed as much charm and savvy in the boardroom as he did in front of the cameras. In an ideal world, he would have delivered a rate hike at Wednesday’s meeting. But economically six weeks hence won’t make much difference, markets received a needed, unambiguous message of regime change from a hawkish Fed chair, and Main Street heard their concerns about accountability and attention to inflation addressed.

Marking to market

As a framework for assessing what we can learn from Kevin Warsh’s first meeting as chairman — and to give me a victory lap — a mark-to-market of my pre-meeting predictions with its outcome and messages is a useful starting point:

• Hawkish, “just the facts” statement: Correct, but I underestimated its brevity and factual focus. Consistent with Chairman Warsh’s desire to end forward guidance, the balance of risks, too, was omitted. This was a clever move as it also made the statement impossible to vote against. All that remained of the statement was a set of indisputable facts regarding above-target inflation and a strong economy, and an affirmation of the Committee’s previous policy stance.
• Declined participation in the SEP: Correct, but interestingly he encouraged his colleagues to participate whereas I had expected him merely to inform them that he would not submit forecasts to be included in the Statement of Economic Projections. This was another savvy maneuver as it sets the precedent he wants without raising hackles that he is imposing change upon the Committee.
• Return the focus to inflation: Correct. The statement emphasized above-target inflation and explicitly committed to delivering mandated price stability. In the press conference, Chairman Warsh mentioned attention to inflation or price stability 16 times and, in his opening statement, described meeting their policy mandate as the Committee’s “North Star,” noting that they are there “to serve our legislative remit…[of] price stability and maximum employment.”
• Sacrifice his productivity views to “epistemic humility”: Correct. While Chairman Warsh never used the phrase “epistemic humility,” it was the underlying theme of the press conference in which he frequently mentioned his openness to new ideas and credited the full Committee discussion with “the kind of humility that I think we should have.” He also walked back his conviction over his productivity views with his (curt) answer to Nick Timiraos acknowledging that “There’s a race between supply and demand” in AI investment that, for “the conduct of policy, [have] timing, scale, speed, implications for output and employment.” He concluded by noting that question would be informed by one of the five task forces that he’s commissioning; the creation of the task forces itself serving both as a demonstration of epistemic humility and a clever way to review past Fed policy without accusation.
• Institutional regime change: Correct. His opening remarks made explicit that “a change in leadership is a natural and timely opportunity to reaffirm its mission, to review current practices, and to consider whether those practices best meet our objectives.” He hammered this message home throughout the press conference by explicitly or implicitly referencing structural changes in approach, methods and priorities more than 20 times with phrases like “fresh look,” “new thinking,” “new chapter,” “moving the Fed forward,” “ask hard questions,” “rethink practices,” and “real reform,” and emphasizing that root-and-branch reform, returning to “first principles,” is needed to make the Fed “fit for purpose,” even if “change isn’t easy.” Beyond words, his five new task forces cover every aspect of Fed operations: communications, balance-sheet strategy (which requires regulatory reform), data collection and analysis, the effects of productivity, and the Fed’s inflation framework.
• “Kitchen sink” the Powell Fed’s failures: Correct. With a velvet glove, Chairman Warsh made clear that he had inherited a record of failure from former Chairman (and sitting Governor) Jerome Powell. Four times during the press conference, including in his prepared remarks, he explicitly referred to inflation being above target for “more than five years,” noting the “hardships” that imposed on average Americans and promising “we’re going to fix that” now that those “are in the rearview mirror.” He made at least a dozen other references the the Fed’s failure to meet its target, to correct missed objectives, to restore its credibility, and to deliver its (mandated) price stability. The message was polite and he never mentioned Governor Powell, but it unambiguously placed the blame for the Fed’s failures with his predecessor.
• Avoiding alienating the Committee: Correct. This is where Chairman Warsh was most impressive. The full first paragraph of his prepared remarks focused on the “warm welcome” he received from the Committee, where he “listened closely to my fellow FOMC members, heard a lot of new ideas, new thinking, and genuine interest in moving the Fed forward.” Throughout the press conference he was gracious to the Committee, complimented them frequently, and went out of his way to represent their views, not just his own: “My colleagues and I discussed them with energy and purpose…I was just incredibly impressed…[they] have been very open about changes…There was no disagreement…It was a pretty gracious couple of days…It’s been a pretty warm few weeks…[and] The institution wants to figure out how we can do better.” This is still clearly a divided Committee. As he noted of the SEP, that half wanted lower rates, half wanted higher rates and that his (uncast) vote would be the tiebreaker. But he managed to get a 12-0 vote, in part through delivering no change, but also by building bridges with his colleagues.
• Rate hike at the June meeting: Wrong. This reflected Chairman Warsh’s savvy. As noted above, economically, it won’t make a huge difference and markets clearly got the message that he is a hawk bringing regime change to the Fed. He put one proposal on the table: no change. That was a move to make friends while he pursues radical change. The statement set the table for rate hikes and, whether intentionally or not, the press did his work for him in helping convince the Committee that action is needed sooner rather than later. Four different reporters stated or implied that the statement effectively demanded a rate hike: Claire Jones of the Financial Times directly, Nick Timiraos of the Wall Street Journal framing it as a credibility issue; Colby Smith of the New York Times probing when; and Steve Liesman of CNBC questioning whether conditions as described were consistent with rates being restrictive (as the Powell Fed continuously described them). Just as notably, no reporters asked whether rates are restrictive or if the Committee was worried about labor market weakness or recession risks.

Lessons learned: a higher likelihood of success

What do I take from this? Well, obviously, I have been right all along that President Trump would appoint a hawk, that it would be Kevin Warsh, that he would actually be a hawk and not a “sock puppet,” and that his underlying mission is root to branch reform of the Fed to restore both its credibility and limited mandate. But I also learned that Kevin Warsh is a far more effective, politically savvy leader than I understood, and as a result I credit him with a much higher likelihood of success in both his short-run need to restore policy credibility and long-run goals of institutional and balance-sheet reform. In his well thought answer to questions about relative prices for average Americans — milk, eggs, beef, gasoline — he even showed his understanding of Themistocles’ lesson: serve and cater to the masses or they will bite you.

And higher rates sooner

While he showed patience where necessary, he also demonstrated that he is moving rapidly on all fronts. That should put on notice markets that are pricing less than even odds for a July move and less than 50bp by yearend. I may have overestimated his willingness to push through a policy move at the June meeting, but I also underestimated his “just-the-facts” approach to the statement and his political acumen. Waiting six weeks to hike rates isn’t economically meaningful but waiting a full quarter is. Further, the longer the Committee waits, the more action will be necessary. The July, September and December Fed funds futures contracts remain attractive shorts in my view, and 2-year/10-year US Treasury flatteners and the dollar both have more room to run.