Kevin Warsh Challenges Fed’s Economic Models and Inflation Strategy

Kevin Warsh, a former Federal Reserve governor, is challenging the central bank’s long-held economic orthodoxy. He argues that the Fed’s reliance on mathematical models and the Phillips Curve, an economic theory suggesting a tradeoff between inflation and unemployment, has failed to deliver price stability. According to Warsh, the Phillips Curve lacks statistical significance, as shown in a Bloomberg chart analyzing data from 1959 to the present. He emphasizes that the current Fed leadership has struggled to control inflation, which has exceeded the 2% target for over five years.

Warsh also dismisses the concept of the neutral interest rate (R*), a theoretical benchmark for monetary policy. He views it as an academic exercise rather than a practical tool for policymaking. Instead, he focuses on operational strategies, positioning himself more as a central banker than an economist. His approach signals a shift away from the Fed’s traditional economic priesthood, which has governed its decisions for decades.

On monetary policy tools, Warsh reinforces interest rates as the primary instrument, suggesting that the Fed’s balance sheet remains accommodative. He acknowledges that different tools, like interest rates and balance sheet adjustments, work through distinct channels. However, he warns that these tools could operate in opposition, creating challenges for achieving stable prices. The political sensitivity of shrinking the Fed’s balance sheet adds another layer of complexity, as any reduction may face resistance.

In financial markets, Warsh highlights a fundamental change in the price of risk, citing the term premium on the US 10-year note. Under Greenspan, the premium was high, but post-Greenspan, it plummeted during quantitative easing (QE), often turning negative. Warsh’s critique underscores the need for a credible inflation-fighting strategy, one that acknowledges the limitations of existing models and the failures of past policies.