Tag Archives: Overton Window

Warsh and Fed Confront a Crossroads On Policies

01 Monday Jun 2026

Posted by in Federal Reserve, Monetary Policy

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A lot has changed since Kevin Warsh was nominated by President Trump to replace Jerome Powell as chairman of the Federal Reserve Board. Most notably that includes the war in Iran, the run-up in oil prices, and a bond market increasingly nervous about inflation as it attempts to digest massive supplies of new Treasury debt. Tariffs have also contributed to the updraft in measured inflation since then, which (in addition to oil prices) represents another impingement on the economy’s supply side.

Change and Change Itself

By the time Warsh was sworn in as chairman, expectations for Fed rate cuts had swung to expectations of a quarter-point increase in the federal funds rate target, if not at the mid-June meeting of the Federal Open Market Committee (FOMC) then in July. It’s not clear that Warsh is on board with that, and the status of the Iranian conflict, oil supplies, and the bond market could change dramatically before the June meeting.

Short-term inflation expectations have risen, so a rate hike by the Fed might seem reasonable if not for the possibility that current inflation is transitory (but I use that term guardedly). In terms of money growth, policy seems roughly neutral to slightly restrictive. M2 growth from a year earlier was 4.7% in April. Nominal (current dollar) GDP grew at a slightly faster 5.1% clip in the first quarter, and it might accelerate in Q2. Real GDP advanced 1.6% from a year ago in the first quarter, but the Atlanta Fed’s forecast for real GDP in Q2 is a stronger 3.2%. Meanwhile, core PCE inflation (the Fed’s preferred gauge) was 3.1% in the first quarter and 3.3% in April. If the numbers roughly follow the same track going forward, nominal GDP in Q2 could be up by about 6% – 6.5% from a year ago. Slowing the rate of M2 growth much from its recent pace might be an overreaction.

Moreover, it might be premature to raise the funds rate when a peaceful resolution to the Iran conflict is still possible. Again, we might know by the time the FOMC convenes in June. In that case, market rates could ease quickly. I am skeptical, however, that Iran will prove to be a reliable partner to any peace agreement. I’ll be surprised if the blockade on the Strait of Hormuz ends any time soon, and a few air strikes have already been renewed. Still, I expect the FOMC to defer any rate hike until at least the July meeting. In fact, I’ll be surprised to see one at all.

Sound Money or Monetary Madness

Many describe Warsh as a “sound money” guy, having been greatly influenced by Milton Friedman. He’s been critical of quantitative easing (QE): the Fed’s purchases of securities for its own balance sheet to provide liquidity to the markets and banking system. If the hostilities continue in Iran, Warsh is more likely to favor quantitative tightening (QT) in the short-term than rate hikes. QT would involve reductions holdings of securities on the Fed’s balance sheet, which Warsh has long advocated.

On the other hand, Warsh has been undaunted in insisting that the AI revolution will be a dramatic deflationary force. That’s a longer-term proposition, but it reinforces his preference for lower rates. So Warsh is for “sound money” and would like to see QT, but he also prefers lower rates and apparently believes that AI might justify a more expansionary monetary posture. So where does that leave us?

Squaring the Circle

A few months ago I described a coherent policy agenda for the Fed under Kevin Warsh, given his policy preferences. It might have lacked realism in terms of Fed politics, but it was motivated by the question of whether lower rates are compatible with QT. The discussion did not anticipate the Iran conflict and its economic and financial consequences.

Lower rates and QT would be compatible if the Fed enables and incentivizes commercial banks to hold more securities and lend more aggressively. This would require regulatory changes as well as reductions in interest on bank reserves (IOR) held at the Fed.

Judy Shelton in the Wall Street Journal has made the same point, characterizing such a policy shift as “pro-market”. That’s because it would allow banks to invest in relatively safe assets, would eliminate a subsidy masquerading as a price (IOR – though fully administered), and would mean a transition from the Fed’s emphasis on maintaining ample bank reserves to scarce bank reserves. The latter would restore activity in the market for overnight loans of reserves (federal funds), which would then trade at a price corresponding to their degree of scarcity. That would provide an important signal to other markets, not to mention the Fed itself. Today, that signal is distorted by the Fed’s provision of ample reserves (repo rates notwithstanding). Jai Kadia and Norbert Michel have made a similar argument, along with advocating for rules-based monetary policy, rather than frequently destabilizing discretionary actions.

Momentum

In April, David Beckworth noted that momentum is building in influential circles for this change, which he describes as a “demand driven” approach, as opposed to the “supply driven”, ample reserve operating procedure now in force. This is the more common at many foreign central banks, and it has received prominent mention in recent speeches and statements by Fed officials. As Beckworth puts it in the title of his post, “The Fed’s Overton Window Is Shifting”.

Beckworth also mentions Warsh’s desire to establish a new Treasury-Fed Accord. The original 1951 Accord established the Fed’s independence from Treasury financing operations. Today’s ample reserves approach has made it far too easy for the Fed to succumb to pressures to monetize deficits and intervene in capital markets to manipulate longer rates. Warsh would surely like to re-establish the Fed’s monetary authority as a separate and independent function from Treasury financing.

The Fed Board of Governors (BoG) must approve changes in interest on reserves (IOR). (Better yet, an act of Congress would be required to prohibit IOR.) But Warsh, who is said to have good relations with the Fed staff and other Fed governors, is less likely to get a majority on the BoG than even the FOMC. For now, he’ll have to be persuasive to gain the support of a majority of either body.

Summary

Kevin Warsh is likely to argue strenuously for reductions in the size of the Fed’s balance sheet, and would almost certainly be happy for the FOMC to defer any rate hikes pending more clarity on a resolution to the Iran conflict. He will also argue for creating greater incentives for banks themselves to invest in Treasury debt, including reformed regulations on bank asset holdings and reduced interest on reserves held at the Fed. Ultimately, that would pave the way for lower rates on a variety of assets. But the Fed should be probably be cautious and gradual in the implementation: the changes to IOR and bank regulations must be well coordinated with QT and money growth must be calibrated to meet the Fed’s inflation target (or better yet, a nominal GDP target — see Part 2 of this post).

Stagflation and the Supply of Bad Public Policy

20 Wednesday Oct 2021

Posted by in Inflation

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Price inflation is getting more attention now than it has in many years, but not everyone is convinced it will persist, most conspicuously bond investors. The Biden Administration’s initial narrative was plausible even if there were seeds of doubt: a price spike was to be expected relative to the low-ebb of price changes during the pandemic. However, the inflation data has come in strong since the spring, and events point to continuing price pressures and the potential for expected inflation to drive escalations in contract pricing. Once embedded like that, the phenomenon broadens and gets harder to squeeze out.

Broadening Price Hikes

The evidence at hand is never enough to take much comfort in predictions, and the uncertainties now are similar to those I discussed in June. At the time, the price moves had been pronounced only in the prior month or so, and there was no evidence of any breadth. Now, it’s at least clear that increases in the so-called “core” Consumer Price Index (CPI), which excludes food and energy prices, have escalated. In addition, the growth in the median component of the CPI basket reported by the Federal Reserve Bank of Cleveland has begun to jump. So has the “trimmed CPI”, which excludes the most extreme 8% of prices changes in both directions within the index. The chart below shows one-month changes in these gauges:

So the recent upward price trends have expanded in breadth, and their persistence is making it a little harder to argue that the changes are transitory rebounds from pandemic weakness.

Bond Investors Still Nonchalant

Investors are by no means convinced that the recent price pressures will persist. They have an incentive to bid-up bond yields to compensate for expected inflation, so these yields can be used to infer inflation expectations. The chart below from the Federal Reserve Bank of St. Louis shows the five-year “breakeven” inflation rate, which is derived from inflation-indexed versus unindexed Treasury securities.

The pattern does not suggest that a meaningful change in inflation expectations has taken place. In fact, the implied five-year inflation forecast has edged down a bit. Of course, we’re still worrying about a fairly short period of high month-to-month changes in prices, and five years is a long time in that context.

This “casual” reaction of interest rates to the inflation spike undoubtedly reflects investors’ belief that the Federal Reserve will tighten policy in an effort to contain inflation. Some of us have strong doubts about the Fed’s inflation-fighting resolve, however. There is little the Fed can do to relieve supply-side problems, and many would argue that the Fed should take an accommodative stance in an attempt to minimize output and job losses, but that would reinforce the inflationary effects. There is no easy way out. Risks loom in both directions, and though I might regret it, at recent yields, I’m not buying Treasury bonds.

Sources of Price Pressure

Economists have tended to divide price pressures into those driven by demand and those driven by supply. Sometimes the terms “demand-pull” and “cost-push” inflation are used for shorthand. The former is usually associated with economic growth, where rising prices indicate that demand is outpacing gains in capacity. With cost-push inflation, however, rising prices indicate that production snd supply is somehow impeded. You get higher prices and lower output. This is so-called “stagflation”. Today we seem to have a combination of those inflationary forces in play: demand has rebounded from the pandemic lows of 2020, while breakdowns in the supply chain have choked production, with a consequent need for more severe price rationing. If the latter forces win out, we will have entered a stagflationary episode.

Unfortunately, administration policies are exacerbating supply-side inflationary pressures. Officials first insisted that the jump in inflation measures would be transitory. More recently they’ve said that it really only hurts “the rich”, an assertion that is decidedly false. Biden flaks are doing their level best to put lipstick on a pig. “Peppermint” Psaki says it shows that people just want to buy things! On the other hand, the Washington Post encourages us to “lower our expectations”. Um, yeah… I think we’re there!

Burning Energy Producers and Consumers

Energy policy is an obvious case: while a hurricane moving through the Gulf of Mexico took a big bite out of domestic oil production, Biden took several steps to hamstring the domestic fossil fuel industry at a time when the economy was still recovering from the pandemic. This included revoking permits for the Keystone pipeline, a ban on drilling on federal lands and federally-controlled waters in the Gulf, shutting down production on some private lands on the pretext of enforcing the Endsngered Species Act, and capping methane emissions by oil and gas producers. And all that was apparently just a start.

As Mark Theisen notes, when you promise to destroy a particular industry, as Joe Biden has, by taxing and regulating it to death, who wants to invest in or even maintain production facilities? Some leftists with apparent influence on the administration are threatening penalties against the industry up to and including prosecution for “crimes against humanity”! This is moronic, of course, but perhaps these extremists are just trying to move the Overton Window. Fossil fuels have been and still are a miracle in terms of human well-being, and renewable (but intermittent) energy sources are simply not capable of replacing the lost power, as Germans, Californians, and Texans are learning. Furthermore, the effort to kill fossil fuels amounts to a war on the poor. Americans are facing steep increases in their utility bills and blackouts during the times when power is needed most. Now, Biden is actively trying to wheedle more oil production out of OPEC, as if it’s okay for those nations to extract it, but not for us to do so!

Labor Shortage

Have you heard it’s hard to get help these days? You’ll notice it pretty fast if you have regular occasion to deal with service establishments. Goods are getting scarce on the shelves as well. Food and paper goods are getting pricier. The semiconductor shortage has been prominent, impacting production and pricing of electronics, computers, and new cars, with a big cross-effect on the used car and rental car markets. Everywhere you look, sellers seem short of inventory. This year it might be tough to fill the space under the Christmas tree for lack of availability.

This isn’t just about cargo ships unable to unload at the ports, although that’s significant. Patrick Tyrell and Anthony B. Kim note the difficulty of overcoming the supply chain breakdowns even with 24/7 operations at the ports. Tyrell snd Kim offer this quite from the Financial Times:

“The US is facing a shortage of warehouse space and truck drivers, and shifting to 24/7 operation will require enormous co-ordination between the publicly operated ports and private sector groups, including large retailers and freight companies.”

There are several reasons for the labor shortage: a few workers and businesses might still be living in fear of COVID, especially in “blue” states and urban areas where the fear factor seems to have been more palpable. That’s where the high unemployment is. There has also been an apparent wave of retirements among late baby-boomers who were already on the cusp of hanging up their skates. However, the Biden Administration has instigated a set of ill-advised policies that blunt work incentives, leading to reduced labor force participation: the repeated extensions of pandemic-related unemployment benefits; increased child and dependent care tax benefits; the moratorium on evictions from rental property; the elimination of work requirements for expanded Medicaid coverage; and increased EBT and SNAP benefits. This is not hard to understand: if you pay people to stay home, they will stay home, even as you suffer through an interminable wait for your fast food. But there might not be a wait at Dunkin’ Donuts, because they’ve been running short on donuts due to “supply chain issues”!

Destructive Public Policy

COVID policy contributed to the early plunge in demand in 2020. Economic output declined, and ramping-up production is not always a simple thing. In this case, it was hindered by repeated non-pharmaceutical interventions and confused messaging from public health authorities. These are issues I’ve felt compelled to address too many times on my blog over the past 18 months. The negative economic effects of these policies continue to linger, and it should surprise no one.

The Democrats’ so-called “social infrastructure” bill, which looks mercifully unlikely to pass without major curtailments in scale and scope, would exacerbate many of the problems cited above. As I’ve noted recently, it’s more of an “infra-shackle” bill for the private economy than an infrastructure bill. For $3.5 trillion (an understatement based on budget gimmickry), we get heavy regulation and taxes, particularly on fossil fuels, subsidies for uneconomic technologies, assorted entitlements with no means testing, wage- and job-killing (and inflationary) hikes in corporate taxes, and other tax disincentives to private investment. The bill would represent a huge reallocation from the private to the public sector via coercion and public competition for scarce resources.

As if that wasn’t bad enough, now Biden has issued his legally dubious vaccine mandate, which has been met with outrage among many workers, from Chicago cops and other public servants, health care workers, truckers and workers at such corporate giants as Boeing, Southwest Airlines, and many others. Unions are furious. People are walking out. This represents a negative “supply shock”, an unexpected event that hinders production and boosts prices. Joe Biden looks to be well on his way to earning the title of “The Stagflation President”.

I’ll leave you with this gem from Brian Dunn: