Warsh's Silent Reaction: Why Transparency Isn't Always the Best Policy

Critics of Kevin Warsh's new approach to monetary policy are fixated on the reaction function, but is this truly necessary?

A promise tied to a date is essentially calendar-based forward guidance, and a promise tied to inflation or unemployment rates is also forward guidance, albeit state-contingent.

Investors will form expectations about how the Fed behaves based on their understanding of the reaction function. Research by Michael Bauer, Carolin Pflueger, and Adi Sunderam shows that these beliefs matter, as perceived responsiveness to economic data affects interest rates and Treasury term premiums.

The authors found that markets learn the reaction function from policy actions after Fed communication fails to convince them. In other words, the Fed communicates its reaction function not by talking but by doing.

Warsh's decision not to provide a schedule explaining how every new piece of data will alter policy may create uncertainty and volatility in the short term, but it is necessary for maintaining central bank credibility and preventing over-leverage in financial markets.