Number Six
Doug Nolan
An old “Helicopter Ben” crack was always good for a chuckle: “Chairman Bernanke is only human.
He puts his pants on one leg at a time, just like everyone else.
And then he prints money.” The former Fed Chairman is clearly one highly intelligent individual (scored 1590 out of 1600 on his SAT!).
His foolhardy inflationist policy prescriptions stemmed from his deeply flawed analytical framework.
I haven’t stumbled across Kevin Warsh’s SAT scores, but his Stanford undergrad and Harvard Law School pedigree suggest well-functioning gray matter.
But what about the soundness of his analytical framework?
During his earlier stint as Fed governor, I was impressed with Warsh’s more traditional central banking reasoning in the face of Bernanke inflationist ideology.
And especially after the past 15 years working closely with Stanley Drukenmiller, I hold elevated expectations for the soundness of Warsh’s analytical framework – if not his capacity to translate it into sound monetary management.
The Fed Chair delivered an impressive presentation at Jackson Hole.
He continues to talk a good game, and his focus on traditional central bank principles is commendable.
“Hawkish Kevin Warsh Hints Fed Will Raise Rates if Inflation Does Not Fall Soon.”
“Warsh Jackson Hole Speech Most Hawkish Since 2009 as Yields Jump.”
“Kevin Warsh: the Hawk at Jackson Hole.”
“Wall Street Piles On Rate-Hike Bets as Warsh Renews Hawking Tone.”
“Warsh Succeeds at Jackson Hole – Convincingly Hawkish.”
“Bond Traders Buy Warsh’s Tough Talk on Inflation, for Now.”
“Fed Chair Warsh Leans Hawkish in Jackson Hole Speech – Markets Approve.”
The “Markets Approve” headline ran after the initial bullish market reaction.
The S&P500 advanced 0.5% on Warsh, with the Nasdaq100 notching a solid (0.4%) gain.
The Broker/Dealer Index rose almost a full percent, with the Banks 0.8% higher.
The VIX (equities volatility) Index dipped to 14.13, the low back to December.
Investment-grade CDS slipped to 50 bps, near the low back to February.
High-yield CDS declined to 298.5, within a couple bps of the low back to early February.
EM CDS traded near lows since early March.
In short, most financial conditions indicators signaled “all’s clear” for unrelenting loose “money” and Credit.
High yield spreads-to-Treasuries narrowed nine bps this week to a near three-month low of 2.60 percentage points – to within 10 bps of the low back to June 2007.
Bond market reaction was similarly fascinating.
Consistent with hawkish messaging, two-year yields popped a quick eight bps to 4.31%.
The yield curve flattened notably, with 30-year yields declining four bps to 5.15% (10-yr yield down 2bps).
The rates market went from pricing 35% probability of a rate increase at the September 16th meeting to 60%, with odds for a hike by October 28th jumping to 92% (from 62%).
It was a “beautiful” market reaction - initially.
Warsh successfully brandished his inflation-fighting credentials, while offering some needed clarity on his thinking and approach.
That said, no one believes the Warsh Fed would dare resort to “slamming on the brakes.”
The market is now pricing two 25 bps increases by next March – with short rates forecast back above 4%.
Rates were at 5.25% to 5.50% as recently as September 2024, a level at the time not generally restrictive for financial conditions.
At this point, it’s perfectly rational for a highly speculative equities market to dismiss a couple small rate increases over the next seven months.
The AI arms race Bubble couldn’t be less concerned by the prospect of a 4% Fed funds rate.
That’s a problem.
After trading down to 4.65% on a hawkish Warsh, 10-year Treasury yields (as they’ve of late tended to do) reversed higher.
Yields traded up to 4.73% - within six bps of the closing high back to October 2023 – before ending the week at 4.72%.
Reading the table, the bond market senses it’s the sucker.
The Fed has adopted a tightening bias, but with no intention of actually tightening financial conditions.
Understandably, the prospect of financing Trillions of Treasuries and AI-related debt, as the Fed tightens up monetary policy, can seem daunting in a rising global yield environment.
I’d feel more comfortable had the President posted on Truth Social his disapproval of Warsh’s hawkish speech.
After the July 29th FOMC meeting and press conference, Trump weighed in: “He’s a brilliant guy.
I know he’d love to see lower interest rates, but he’s got a board, and it’s a political board, and they want to keep rates up.
But we fight through rates.”
I’m imagining the Treasury Secretary in a tension-filled Oval Office.
“Mr. President, you are doing such an incredible job with the ballroom.
Pure genius, sir.
And don’t worry about Kevin.
He’s fully on board.
He just has to play the game of talking a little tough so he won’t actually have to raise rates.
The Dow was basically unchanged today – just off all-time highs.
We’re good on this, and you know I’m locked and loaded in the event markets start to waver.”
Warsh from Jackson Hole:
“To get policy right, we also need to get the relationship right between financial markets and the central bank.
The Fed needs clear market signals, as unfiltered as possible… from market internals… the level and change in asset prices across sectors… the prices and trading volumes of Treasury securities… the foreign exchange value of the dollar… the cost and availability of credit… and the price of a broad set of commodities.
These and other indicators should inform the Fed’s near-term outlook on economic activity and inflation throughout the business cycle.
They should also reveal the state of broader financial conditions… and the risks and uncertainties in the financial cycle.
At the same time, market participants themselves should be tracking real information across the economy.
They should draw their own conclusions; form their own expectations of output, employment, and inflation; and stay sharply attuned to risks.”
I applaud the Chair’s framework – including his emphasis on the “cost and availability of Credit” and “the state of broader financial conditions…”
But after QE1, QE2, open-ended QE, “whatever it takes,” the pandemic free-for-all, and decades of recurring Fed and Washington liquidity backstops - markets staying “sharply attuned to risks” is pure fantasy.
Additional appreciative applause for Warsh’s seven stated principles (my abbreviations):
1) “In other words, we must interrogate reality to make sure we are not setting forward-looking policy based on stale or inaccurate data.
Nor should we rely on isolated data points.
Trends matter most.”
2) “The Federal Reserve’s actions are intended to ensure that the aggregate demand side of the economy is broadly consistent with aggregate supply.”
3) “The Fed’s price-stability objective of 2%, as measured by the personal consumption expenditures (PCE) price index, is a firm, fixed target…
Price stability is not self-executing, nor is inflation necessarily mean-reverting.
It is the Fed’s job to deliver stable prices.”
4) “The Fed also bears responsibility for maximum employment.”
5) “Short-term interest rates are the predominant tool to achieve the dual mandate.
Unconventional policies to spur economic activity may suit genuine crises but should otherwise be used sparingly, if at all.”
6) “Money matters.
It’s not fashionable these days, but my view is that money has something important to do with monetary policy.
We should pay attention to money created by the central bank and money that comes from the banking and financial systems.
It’s true that financial innovations and other factors alter the mechanics that link the monetary base, the velocity of money, and the broader economy.
But that is scarcely a reason to ignore the ultimate effects of money on financial conditions and prices.”
7) “A quieter Fed, more purposeful in its communications, is better able to meet its objectives.
And we can be held accountable for delivering on our remit—the only true test of our credibility.
To borrow a line from General Chuck Yeager, ‘At the moment of truth, there are either reasons or results.’”
As much as I appreciate #5 (and a good Chuck Yeager quote), principle Number Six finds a special place in my analytical heart.
Has Kevin Warsh just opened the door for contemporary monetary analysis?
Such essential subject matter for sound analytical and policy frameworks has somehow been MIA throughout this multi-decade Bubble period.
“Money” has been an ongoing Warsh interest.
He footnoted principle Number Six with a 2022 paper published by the American Enterprise Institute (a chapter in American Renewal, a book edited by Paul Ryan and Angela Rachidi): “Money Matters: The U.S. Dollar, Cryptocurrency, and the National Interest.”
Warsh:
“Most money used by the public sits in digital form in accounts at commercial banks.
The safety of this so-called commercial bank money is predicated on deposit insurance, capital requirements, and the quality of supervisory and regulatory oversight.
Its value is also a function of the commercial banks’ access to central bank liquidity.
When commercial bank money has a call on the central bank of the strongest sovereign in the world, it’s deemed safe and sound.
The nexus between the commercial bank and the central bank is where the alchemy happens.”
“As Ravi Menon, the highly capable head of Singapore’s central bank, stated: ‘The credibility of money is underpinned by this two-tier monetary structure where commercial banks create money and central banks preserve its value.’”
This is exciting.
And, holy cow, what a can of worms our new Fed Chair has just opened!
And we can go back to the mid-60’s Milton Friedman and (John) Gurley & (Edward) Shaw debates.
Friedman, the devout monetarist, exhorted the Fed to manage the money supply to control inflation.
Seems simple enough.
But when asked to define “money”, he struggled and defaulted to a narrow monetary aggregate.
Critics argued that if you can’t define it, how are you supposed to manage it?
Gurley & Shaw focused soundly on broad money-like financial instruments and financial intermediation more generally.
Their superior analytical framework notwithstanding, they lost the debate.
I commend Warsh for reintroducing “money” in Fed policy analysis.
But his comment from 2022 – “Most money used by the public sits in digital form in accounts at commercial banks” – is even more archaic these days.
Total money market fund assets have inflated 10% over the past year to $7.935 TN, with historic inflation of $3.35 TN, or 73%, since October 2022.
Surely Warsh appreciates that current monetary inflation is dominated by booming Wall Street - “repo,” money funds, hedge fund leveraging, derivatives, “basis trades,” “carry trades,” and securities finance more generally.
“The nexus between” Wall Street “and the central bank is where the alchemy happens.”
Money Matters, financial conditions, Wall Street finance, Credit Bubbles, assets inflation and speculation leverage.
Let this critical - and long overdue - debate begin!
I don’t want to get too carried away, but injecting “money” into the Fed’s analytical framework kind of turns contemporary central banking orthodoxy on its head.
As a regular listener, I’ll give a shout out to Tracy Alloway and Joe Weisenthal’s “Odd Lots” Bloomberg podcast.
In Thursday’s episode, they interviewed the host of the Jackson Hole Economics Symposium, Kansas City Fed President Jeffrey Schmid.
I’ll highlight a particular question asked by Tracy Alloway, one I encourage journalists to replicate for all Fed officials, certainly including at Chair Warsh’s post-meeting press conferences.
“When you look at financial conditions now, do you think that something fundamental has changed in the U.S. economy, such that perhaps we’re more accommodative than we would have been otherwise?”
Jeffrey Schmid’s “we’re at a fairly accommodative place for rates right now” was a reasonable response that missed the essence of such a critical issue.
All one needs to do is examine current financial conditions indicators (loose across the board) in the context of today’s long list of extraordinary risks - and it’s clear that there have been both fundamental and monumental changes.
The explosion of unfettered non-bank Credit creation fundamentally boosted Credit Availability and growth.
The explosion of Wall Street finance (i.e., money funds, repo, hedge funds, derivatives, etc.) fundamentally amplified marketplace liquidity, asset inflation and speculative excess (while providing Washington a blank checkbook).
Resulting market, financial and economic instability then fostered ever-greater Fed, Washington and global market and liquidity backstops/bailouts – fundamentally distorting risk perceptions and market function.
The Treasury market had no qualms, so long as bond price inflation (lower yields) remained the epicenter of contemporary monetary inflation.
But liberated inflationary effects now dominate in an epic stock market Bubble; with elevated consumer and producer prices; and for a historic AI arms race, to note the most obvious.
Today, ongoing loose conditions pose major bond market risks (i.e., inflation, issuance, deleveraging…).
Our Fed Chair Friday outshone even our Treasury Secretary when it comes to sparking fascinating discussion.
August 25 – Financial Times (Robin Wigglesworth):
“Stanley Druckenmiller is not only a bona fide Wall Street legend, the hedge fund manager is also a longtime mentor of both US Treasury secretary Scott Bessent and Fed chair Kevin Warsh.
Bessent himself told the FT last year that ‘in macro, there’s Stan and then everybody else’.
Which is why this must be exceptionally embarrassing for the protégé:
[Drukenmiller]:
‘The Treasury Department announced on Aug. 19 that it would double the size of its long-dated bond buybacks, from $2 billion to at least $4 billion per operation, aimed at the 10- to 30-year sector and running from Sept. 9 through Nov. 4.
The announcement came after the 30-year yield touched a 19-year high.
Yields fell within minutes.
By the next afternoon they had round-tripped to levels above where they started.
The market’s verdict was swift and correct: This wasn’t liquidity management, it was price management — and a mistake far larger than $4 billion suggests…
The bond market wasn’t being a vigilante, as some would argue.
It was being a pushover that had finally begun to clear its throat, and Treasury moved to quiet even that…
Every basis point of artificial yield suppression is a subsidy to procrastination.
Suppressed long rates sugarcoat the interest-cost projections, shrink the apparent urgency, and let incumbents assure voters the debt is someone else’s problem.
If Congress and the administration are unlikely to touch entitlements even with the market’s signal, they are certain not to touch them without one.
Whatever this operation saves in basis points, it will cost multiples in delay.’”
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