Kevin Warsh recently presided over his first Fed meeting and delivered his first press conference. It was less about the past and more about the Fed’s operational future under new leadership.
On the surface, much was the same. The FOMC delivered an expected outcome, leaving the target range for the fed funds rate unchanged at 3.50% to 3.75%. The vote was unanimous, and the committee reaffirmed its policy of maintaining ample reserves in the banking system, while delivering maximum employment and price stability. But under the hood, Warsh left clues about where the Fed may be headed. Let’s review.
The Backdrop
Warsh steps in at an interesting time. US equities are near all-time highs. First quarter GDP was revised up to 2.1% from 1.6%. Oil prices are down 30% from the Iranian conflict high, providing relief at the pump for summer travel while easing near-term re-inflationary fears.
Equity returns have diverged meaningfully through the first half of the year. Take a look at the below chart. Semiconductor stocks, as tracked by the ETF SMH, are up 76% so far this year. The S&P 493 is up 14%, but the Mag-7 are down 7%. The market seems to be discounting the capital spend by the Mag-7 but celebrating that same spend in accelerating revenues elsewhere.
Delivering appropriate monetary policy amongst this backdrop in an era of fiscal dominance is a challenge. Since the Great Financial Crisis, the Fed has been more communicative and more ‘central’ to market behavior. It owns a big balance sheet. It gives regular press conferences. It publishes dots. It guides expectations and manages liquidity. Warsh’s first meeting suggested he intends to revisit the entire machinery. So, he announced five “task forces” to review the Fed in five key areas:
- Fed Communications
- Fed Balance Sheet
- Use and Reliance on Existing Data Sources
- Productivity and Jobs in an Era of Transformation
- Fed’s Inflation Frameworks
Let’s briefly review each task force.
Fed Communications
This centers around forward guidance. Warsh’s initial policy statement was noticeably short. It removed the old language from Powell’s past. Gone was the elaborate discussion of risks, incoming data, and a collection of carefully balanced phrases. Warsh said the statement dispensed with forward guidance. Or, more simply, the Fed may stop pretending it knows the future.
Forward guidance had a very specific purpose during the Great Financial Crisis to alter behavior and unlock frozen credit markets. But over time, it’s become more show than substance, treating every word from the Fed as a trail of breadcrumbs. Each sentence interpreted as a clue to the next meeting.
And the problem with that is the recent Fed’s own guidance has not been especially reliable. Powell was too quick to raise rates in 2018, then too slow to raise them in 2022. Warsh seems to be saying: enough with the false precision. Instead of telling markets what the Fed might do three, six, or twelve months from now, he wants to keep the focus on the objectives. Those objectives remain price stability and maximum employment.
Fed Balance Sheet
Task force #2 is the Fed balance sheet which currently holds $6.7 trillion in assets. The balance sheet and its mechanics are crucial financial plumbing for markets. However, Warsh has long been a critic of balance-sheet bloat. He sees the post-GFC balance sheet as mission creep. A large balance sheet blurs the line between monetary and fiscal policy. As assets roll off, the Fed purchases securities of certain maturities, which can influence liquidity conditions and the Treasury’s issuance decisions.
But last week, Warsh didn’t come in swinging a big stick. Instead, he opened a formal review of the Fed’s holdings. The second sentence of the Fed statement read “The Committee reaffirmed its policy of maintaining ample reserves in the banking system.” This tells me Warsh prefers a smaller balance sheet, but he understands the financial plumbing matters more. The distinction is critical. Bank reserves, money markets, and Treasury market liquidity are all connected to the Fed’s balance sheet footprint. Shrinking the balance sheet may be the appropriate long-term goal, but doing so haphazardly could create unnecessary market stress.
So, the balance sheet task force is both technical and philosophical. Technical because the Fed must determine how much liquidity the system needs. Philosophical because Warsh appears to be asking whether a Fed balance sheet is appropriate in the first place.
Use and Reliance on Existing Data Sources
Garbage in, garbage out. Bad data leads to bad decisions. Traditional economic data points can be messy. They are delayed, revised, and backward-looking. Warsh said it well in his press conference: “Trends matter more than data points.” The Fed should not overreact to one data point, but it also cannot ignore a trend simply because each individual data point can be explained away.
This was the misstep in 2021. The inflation trend was firmly intact, but the Fed remained attached to “transitory” explanations and a step function of forward guidance. Had the previous regime been more focused on trend, they likely would have started hiking sooner. This task force is about improving the Fed’s inputs. Are they looking at the right data? Are there better real-time indicators that can help identify appropriate policy stance sooner rather than later? A full review is necessary.
Productivity and Jobs in an Era of Transformation
Artificial intelligence, automation, and capital investment are changing how businesses operate. If productivity growth improves, the economy may grow faster while also reducing inflation pressures. This matters enormously for monetary policy. Warsh appears to understand that the Fed might not be able to use yesterday’s framework to analyze tomorrow’s economy. If the economy’s speed limit is higher than the Fed thinks, it risks overheating the economy. Overestimating productivity gains risks overly restrictive policy. A difficult balance, but one ripe for review.
Inflation Framework
The final task force focuses on the Fed’s inflation framework. Warsh has previously remarked he cares about the inflation number left of the decimal point. Does this lead to re-work of the 2% inflation target? When asked, Warsh was non-committal and retreated from his previous musing. But the fact that it’s included amongst the task forces is important. Warsh’s first statement ended with the statement of the objective: “The Committee will deliver price stability”. That may be the clearest summary of the Warsh Fed so far. Less explanation. Less prediction. More emphasis on the objective.
The Takeaway
For my US golf fans, the phrase “task force” may bring back painful Ryder Cup memories. In 2014, the PGA of America assembled a task force to overhaul the U.S. Ryder Cup process. The results have been bleak. Since then, the U.S. is 2–4 in Ryder Cups. Warsh’s task forces, however, are more important. They are a roadmap of what he believes deserves a fresh look: Fed communications, its balance sheet, what data it relies on, how it measures productivity, and how it defines success on inflation.
For investors, the implication is that the Warsh Fed may be less conversational and more disciplined. It may offer less comfort, less forward guidance, and fewer market-friendly breadcrumbs. Powell often tried to reduce uncertainty for markets. Warsh may be more willing to make markets price uncertainty themselves.
Have a great week!
-Matt
Sources: Ycharts, Federal Reserve Board of Governors
This communication and its contents are for informational and educational purposes only and should not be used as the sole basis for any investment decision. The information contained herein is based on publicly available sources believed to be reliable but is not a representation, expressed or implied, as to the accuracy, completeness, or correctness of said information. References to political figures or policies are for informational purposes only and do not represent an endorsement by Waddell & Associates. Any forward-looking statements reflect current opinions and assumptions and are subject to change without notice; actual results may differ materially. Past performance does not guarantee future results. Waddell & Associates may use artificial intelligence tools to help generate or summarize content; all outputs are reviewed by our team for accuracy and relevance.
