Waller vs Warsh: Finding the Fed’s strike zone

Anyone who has worked in any organisation would agree that it is not unusual to have some level of disagreement amongst the top decision makers. When those disagreements are between the two most important members, though, and are made public, they introduce an additional layer of uncertainty for stakeholders. This appears to be the case at the Federal Reserve (Fed), where Chair Kevin Warsh's views increasingly seem to clash with those of Christopher Waller, one of the most respected members of the Federal Open Markets Committee (FOMC), not least because he has been the first mover on more than one occasion when it comes to changing views about monetary policy and inflation post Covid, with other FOMC members adopting similar views soon after.

One of the defining features of Warsh’s tenure as Fed Chair so far has been his reluctance to provide guidance to the market. As he describes it, the market should look to “play the ball, not the referee”. Simply put, the market should stop trying to predict what the Fed is going to do based on what the Fed is saying, and instead price financial assets according to what the economy is saying. Chair Warsh’s logic is that he wants an “unfiltered message from the market” and believes the Fed destroys that signal by talking too much.

While we took positives from some of the clarifications Chair Warsh delivered at Jackson Hole, the key issue for investors is less his reluctance to offer forward guidance and more the lack of detail around any form of reaction function. The market then trades not just on what it thinks the Fed might do based on a set of economic data but also on the uncertainty itself, thereby building term premium into the curve and driving the sort of steepening we saw after the July FOMC meeting, which was partially reversed after Jackson Hole.

Waller described his views in a speech yesterday using another sports analogy, arguing that the contours of why the Fed might act as it does is useful information for markets and indeed the economy. He said, “I view myself as a home plate umpire in baseball… the players don’t expect the umpire to have a perfect strike zone – they just need a rough idea of its parameters and some guarantees that it won’t change much on every pitch”.

This is a useful description. After all, Chair Warsh wants the market to form its own view of the economy. But its own view to do what? Until a future president chooses this writer (interestingly, a President could choose someone to sit on the board who is not a US citizen), I’m not sure the view on what I would do matters to the Chair particularly. Ultimately, the market is building a view of what it thinks the Fed and other actors might do based on the economic landscape. Chair Warsh can reduce forward guidance, but if you provide less clarity on your reaction function, you introduce uncertainty, and therefore the effectiveness of the signal reduces.

But the differing views are not only about Fed communication. Interestingly, Waller had some comments yesterday about current inflation that seem at odds with Warsh's hawkishness at Jackson Hole. Governor Waller noted that three-month core inflation had declined from 4.76% at the beginning of the year to 3.05% now, and wage growth is consistent with core inflation of 2%, while the policy rate is “slightly restricting” aggregate demand. Chair Warsh, however, highlighted last week that he would be “hard pressed to describe broad financial conditions as restrictive”, that underlying trends have not meaningfully improved, and that wage growth has “not proven to be a reliable indicator of future inflation for a very long time”.

We would take the comments from the Chair as an indication that he will vote for a hike in September. We will take the comments from the Governor as an indication that he will not. Both are, of course, contingent on data received before the next meeting, including today’s nonfarm payrolls. Current market pricing puts the decision close to a coin flip, with around a 54% probability of a hike at the time of writing,  a fact the previous Fed Chair would have likely sought to influence one way or the other before the meeting, and one markets would have seen as a reasonable thing to do. The data will determine the September decision, but let’s hope markets get a clearer picture of the “strike zone” before the pitcher throws the ball.