The Pivot to Opacity

Kevin Warsh faces monumental choices; but his most significant decisions have already begun.

Source: Official White House Photo by Daniel Torok.

A New Kind of “Stress Test”

The Trump administration’s second term has seen the Federal Reserve fall victim to incessant lobbying, abuse and threats from a president championing lower interest rates. Former Chair Jerome Powell faced direct insult - including “numbskull” and “moron” - with digitalisation publicising what became a prolonged and ugly affair. 

This threat to institutional independence, the deterioration of relations with government, and the aggressive disparagement of the Chair have triggered great concern regarding the central bank’s credibility. For an institution of such global and domestic economic significance, an erosion of trust carries profound consequences.

This disruption only heightens a stark period of transition: Powell’s term as Chair has ended and he has been replaced by Kevin Warsh, a Trump-endorsed pick. Following his departure, Powell voiced concern for this forthcoming phase, warning that the “Fed is Undergoing a Stress Test” - a direct reference to the nascent threat of political lobbying.

The metaphor of a “Stress Test”¹ is highly deliberate. It implies that Powell views current challenges as a baseline assessment of the institution’s credibility and operational capacity, providing critical data regarding the institution’s resilience to withstand more difficult times. 

Crucially, this is a transitory period on two fronts. With US inflation pushed to a three-year high of 3.8% in April, expectation of this figure to rise to 4.2% in May, the data lacks any previous ambiguity: it points to future rate hikes, rather than cuts.Whilst geopolitical tension certainly plays a role, core CPI data - excluding volatile food and energy prices - illustrates that rising prices cannot all be attributed to the war. This is a long-term trend, rather than short-term blip. 

Source: CNBC (Bureau of Labour Statistics)

Yet, downward lobbying from the president continues. This is no longer just a hypothetical “stress test”; the difficult times have arrived. 

There is no doubt Kevin Warsh faces monumental choices, but his most significant decisions have already begun.

The "Only Game in Town"

A “fragmented decade” has made central banks the “The Only Game in Town”² - a phrase to describe how their role has expanded beyond their original mandate to essentially control the entire economy - (a point raised by the departing head of the Bank of France in his special report for The Economist.)

Political timidity paired with economic uncertainty has led to monetary policy being exerted and manipulated to the point of distortion. As this trend persisted, interest rates became the default solution to all macroeconomic problems, leaving the central bank’s primary role of maintaining price stability forgotten under this new, overextended authority. 

However, in broadening their scope to manage every economic crisis, these institutions have heightened their own vulnerability. 

The Vulnerability of Openness

Historically, the expansion of central banks’ role has come with an expansion in their transparency, through increased communication, economic forecasting, and public airing of policy discussion. This has enabled public expectation to be harnessed as a powerful policy tool, whilst also allowing for greater coordination between governments and central banks, facilitating the shared responsibility of economic management. 

A notable example from the Fed is Powell’s use of forward guidance in navigating the post COVID-19 recovery. By explicitly stating that interest rates would remain near 0% until the labor market reached maximum employment and inflation moderately exceeded 2%, the Fed encouraged a continued expansion in aggregate demand without actually changing any hard monetary variables. 

Image: Powell during the FOMC September 2020 meeting. Source: Bloomberg

However, despite the proven merits of openness, Warsh has strongly signalled a reduction in transparency. He has introduced actionable plans to cut back on forward guidance, omit easing/tightening biases, and eliminate the Fed’s ‘dot plot’ - a quarterly chart that illustrates where top policymakers expect short-term interest rates to be in the short and long term.

A Strategic Retreat

At first, this seems like a step backward. Yet, in such a fraught environment, his rationale makes perfect sense. When aggressive lobbying sparks contention and internal dissent runs high, co-operation dissolves into conflict and guidance morphs into uncertainty.

Transparency was once crucial to the role of Central Banks as “The Only Game in Town”. However, we have entered an environment where the strengths of openness have become its greatest vulnerabilities. This means a strategic retreat may well be a move for the better.

The financial world waits with anticipation for Warsh’s decisions on interest rates. However, in this pivot to opacity, he has already made his most consequential move. It is the first step toward restoring damaged institutional credibility and undoing the exertion that has stretched central banks for far too long.

The Fed’s most powerful statement may well be its silence.

---

FOOTNOTES

1 – A practice carried out by major banks to ensure they have the financial resilience to deal with unprecedented economic shocks

2 – This term was coined by the economist and former PIMCO CEO Mohamed El-Erian in his book of the same title, exploring this idea in great depth