July FOMC Reaction: A question of credibility

Research evidence excerpt

July FOMC Reaction: A question of credibility

IdeaMgeneralized change in prices that are happening in the economy."

More comfortable with front-end volatility. Even though Chair Warsh places a lot of

weight on market movements and financial conditions, he also said the Fed's job is "to

learn from those signals, not mechanically follow them." In other words, the Fed should

talk less, take a step back, let markets call balls and strikes, and then the Fed should

debate what is the right course of action. This suggests to us that he has a greater degree

of comfort with volatility. He wants to see the market moves, interpret their meaning, but

not necessarily validate those views.

A murky interest rate transmission mechanism. On one hand, Chairman Warsh appears

to believe that higher interest rates can be part of the solution to reduce inflation and

expressed a general willingness to tighten policy when underlying inflation is too high.

However, he does not appear to view monetary policy primarily through a traditional

aggregate-demand-management framework. He repeatedly backs away from any trade-off

between higher interest rates, softer demand, and weaker labor market conditions, saying

there is no explicit trade-off. This may be true in the longer run – achieving price stability

can improve long-run macro outcomes – but standard central bank thinking says higher

interest rates that lead to softer demand can help reduce inflation, and this can often

mean temporarily softer labor market conditions.

Instead, we read his comments to say that he sees monetary policy operating through a

combination of financial conditions, real interest rates, market prices, credibility, inflation

expectations, and balance-sheet effects. This in and of itself is not controversial. However,