Warsh's Silence on Reaction Function Sparks Criticism, But Is It Just Forward Guidance?

Kevin Warsh's new approach to monetary policy has been met with criticism from those who insist he articulate the Federal Reserve's 'reaction function'. This would require him to describe in detail how interest rates will adjust as inflation, unemployment, growth, and financial conditions change. However, critics of this demand argue that it is largely a distinction without a difference, as a promise tied to a date or specific economic indicator is still forward guidance.

A recent study by Michael Bauer, Carolin Pflueger, and Adi Sunderam found that investors do form expectations about how the Fed will behave, which affects bond yields, stocks, the dollar, and credit spreads. However, they also found that a well-understood reaction function can help investors anticipate what the Fed will do before officials tell them.

The study's authors concluded that markets learn the reaction function from policy action after communication fails to convince them. In other words, the Fed communicates its reaction function not by talking but by doing. The demand for more explicit talk about the reaction function is not well-grounded in economic theory or research.