Analysis: Fed Chairman Warsh’s credibility in question after leaving interest rates unchanged

For a Federal Reserve chairman who prizes credibility above all other virtues, the market’s reaction to Kevin Warsh’s remarks Wednesday must have been painful. 

Warsh hosted a news conference Wednesday afternoon following a meeting of the Federal Open Market Committee, which voted 9-3 to leave interest rates unchanged. It was just the second such meeting since Warsh became head of the Fed on May 22. Investors responded by sharply lowering the chances that the Fed will raise interest rates at its next meeting but also raised the yields on long-term government debt. 

After the news conference, the yield on the 30-year Treasury hit its highest level since 2007, while the yield on the 2-year Treasury fell. The chances that the Fed would leave interest rates unchanged at its next meeting jumped by 20 percentage points to 45%, according to CME FedWatch.

That dynamic suggests investors believe the Fed won’t act immediately on inflation readings that by Warsh’s account have been above the Fed’s 2% target for at least 63 months, and that it may have to act on more aggressively later as the economy heats up for the long haul. 

Before taking the job, Warsh sharply criticized his predecessor, Jerome Powell, when long-term Treasury interest rates moved up after the Fed cut the federal funds rate and said repeatedly that the underlying problem was Powell’s lack of credibility. The situation Wednesday was slightly different, in that the Fed didn’t cut interest rates but held them steady. Warsh also suggested Wednesday that recent rises in long-term interest rates may have reflected positive economic news, such as strong business investment. 

Still, few in the markets saw it that way.

Warsh needed to articulate what it would take for him to want to eventually raise interest rates in the face of stubborn inflation, Jon Hilsenrath, a longtime Fed watcher, wrote in a note to clients after Warsh’s news conference. 

“Warsh didn’t convey the message clearly or explicitly, and the bond market puked on him,” Hilsenrath wrote.

Warsh declined to answer reporters’ questions about the details of why he, along with eight others on the FOMC, deemed the interest rate was in the right place at 3.5%-3.75%, where it has been for months. Warsh has shifted Fed policy by ending a practice known as forward guidance. Past Fed chairs would strongly signal where they expected interest rates to go in the future. Warsh believes forward guidance made the Fed inflexible and obscured signals from the markets. As a result, he doesn’t talk much about how he makes decisions. 

“I understand the desire for rolling forecasts and commentary from this committee, but for our part, we need to observe market reaction to developments, direct and unfiltered,” Warsh said in his opening remarks Wednesday. 

The news conference that followed left some economists baffled.

“I thought today’s press conference was confusing and often internally contradictory,” Eric Winograd, chief U.S. economist for AllianceBernstein, wrote to clients.

Consumer price index data showed prices declining by 0.4% in June, offering an opportunity for the chairman to seize on some positive economic data. But Warsh said that factor was “not much” of a consideration for him, while affirming inflation was still “elevated.”

The Fed is officially committed to achieving 2% annual inflation over the long run in an alternative measure of inflation, the personal consumption expenditures index. Warsh wasn’t much clearer on whether he was happy with that data either, which was at 4.1% in its most recent reading, and added that one of the five task forces he has appointed to review reforms at the Fed might want to downplay PCE as the central bank’s official target when it issues its report at the end of the year. 

We are sticking with PCE for now, Warsh said. But, “who knows, come after next January, what we might say about strategy.”

Warsh’s unwillingness to say exactly what might move him to raise interest rates, combined with his suggestion that he wasn’t committed to the Fed’s reliance on PCE, had some in the markets re-evaluating his brief tenure.

“Both of these points raise questions about the new chair’s credibility in delivering lower inflation,” wrote Michael Feroli, chief U.S. economist at JPMorgan Chase. 

The Fed chairman doesn’t set interest rates alone. He is one of a dozen votes on the FOMC. Three voters dissented from Wednesday’s decision to keep interest rates steady. If economic data doesn’t improve rapidly in the next few months, more may join them.

“We believe this will add some urgency for the rest of the committee to act on its mandate,” Feroli wrote. A Fed chair has never been in the minority on a vote about interest rates.

That leaves Warsh in a difficult place, with his credibility potentially eroded in the face of the markets and within the Fed itself just months into the job.