Former Fed Governor Kevin Warsh, one of the most outspoken and critical members of the Fed's extended family by far, lashed out at the prevailing groupthink that has permeated the Federal Reserve in a speech delivered moments ago at the Hoover Fed Conference titled "The Battle of Ideas", in which among other things he explained that the Fed has no real strategy on policy normalization, asked "what could possibly go wrong" and, unlike all his former colleagues, provided an honest answer.
Here are some select excerpts from his speech:
According to popular lore, the Valley finds itself in the middle of long epoch of prosperity. And we are assured this is a sustainable, durable equilibrium.
What could possibly go wrong?
That is the central question central bankers should be asking.
(Tail risks run in both directions. A subject for another day is ‘what could possibly go right’? The more material constraint on further economic expansion is on the productive side of the economy. If a pro-growth reform agenda were adopted across a range of macroeconomic policies, higher labor and capital supply into the real economy would cause economic growth to track substantially above Fed forecasts.)
On fake markets and the death of price formation:
We should allow asset prices to be an independent source of economic insight and discipline.
On peak groupthink
Leading Fed officials are confidently predicting a benign external environment for the next several years: steady growth, stable inflation, and financial assets trading at fair values. Policymakers have all but proclaimed their monetary mission accomplished, their employment and inflation targets largely achieved. The dot forecasts from members of the FOMC are nearly on top of each other.
The last time I recall such uniformity of opinion—among central bankers, academics, and market pros-- was just over 10 years ago.
On why he is worried:
Maybe the scars of the last crisis burden me with unnecessary worry. Maybe the levers of macroeconomic policy are sufficiently improved such that business, economic, credit, and financial cycles are an artifact of history. Maybe the economy gets another decade of moderate growth and inflation.
On the Fed's faulty forecasts:
My crystal ball is scarcely perfect. But neither is the Fed’s. The most important forecaster trait is humility. The most important forecaster trait is humility. The most important forecasting measure is the confidence interval, not the point estimate. The most common forecasting error is groupthink. The best forecasting fix is assemble a humble, independent, diverse, intellectually rigorous, and cohesive group. The Fed has a lot riding on its outlook, and its institutional inclinations give me pause. Policymakers should evaluate the tail risks of their forecasts with more care than the central tendency. And scrupulously judge their ability to respond in less likely, but more disruptive scenarios.
On the need to reorganize the Fed:
Changes are in order to how the Fed organizes itself, conducts its business, deliberates policy choices, and makes its monetary policy decisions. In short, deliberations should be more robust, and decisions less constrained. The existing governance structure reinforces a groupthink of the guild. It places the Fed at considerable institutional risk when the next crisis strikes. And it makes the next crisis more likely to be more harmful to the economy.
A list of what should not be done:
- We should not mistake the present situation for permanence.
- We should not confuse the post-crisis period of benign, however modest, aggregate macroeconomic conditions with a sustainable, durable equilibrium.
- We should not be comforted by the low implied measures of volatility across financial markets. We should query whether a sudden shift in expectations would make asset prices an amplifier of distress rather than a shock-absorber.
- We should not encourage the financial markets to be the handmaiden of the central bank. We should allow asset prices to be an independent source of economic insight and discipline.
- We must not allow a failure of imagination, a failure of preparation, or a lack of courage to keep monetary policymakers from pursuing a robust reform agenda equal to the risks ahead.
- And we should not conflate a forward-looking policy of reform with a policy of revanchism, pining for the good old days when monetary policy was ostensibly perfected. The conduct of monetary policy has never been easy or simple. And the lessons learned in the last decade about money, credit, banking, finance, markets, and global interconnectedness should be incorporated into a 21st century monetary framework.
His troubling conclusion:
When the next shock strikes, the Fed is unlikely to have conventional or unconventional armaments in sufficient supply.
It is safe to say that none of these recommendations will be adopted by the career economists at the Fed.
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But for us, the punchline was the following: Warsh's admission that despite the daily rhetoric and constant jawboning, the Fed really has no exit policy;
I am confused by the Fed’s ‘normalization’ strategy in monetary policy. Its preferred sequencing of rate increases and balance sheet reductions differ markedly from what was agreed when we conceived QE in the ’war room’ amid the crisis. There might be good reason. But, the transmission mechanisms of rate changes and balance sheet adjustments are markedly different than projected. So too are the distributional effects. This merits a more robust public explanation.
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Full speech below (link)