Kevin Warsh, a former Federal Reserve governor, advanced an important critique of the U.S. central bank last month, accusing it of mission creep with disastrous consequences for the economy and its own public standing.
The April speech, delivered in Washington D.C. to a collection of economic policy dignitaries known as the Group of 30, was consequential in part because Warsh is a former insider of the Fed; he deserves some credit for offering reasoned skepticism of a generally insular institution. It’s also important because Warsh might soon run the Fed. He’s widely considered a leading contender for the job when Jerome Powell’s leadership term expires next year, and has reportedly advised the president peripherally on central bank matters.
The former Fed governor charged the Fed with distraction and inconsistency that resulted in an inflation outbreak, large federal budget deficits, and damage to its own independence. Its problems are largely self-inflicted, Warsh concluded, and cry out for “strategic reset” of the central bank.
“Institutional drift has coincided with the Fed’s failure to satisfy an essential part of its statutory remit, price stability,” he told the gathering. “It has also contributed to an explosion of federal spending. And the Fed’s outsized role and underperformance have weakened the important and worthy case for monetary policy independence.”
The criticism raises an obvious two-part question: Is he right, and what does his critique portend for the institution he seems to want to run?
Warsh’s account has appeal for a president and political base that place elites and the institutions they run at the core of America’s economic and social ills. Among other things, Warsh argued at length,the Fed took its eye off the inflation problem because it was distracted by issues like climate change and diversity and inclusion, central laments of the Trump movement.
Inflation hawk
On a practical level, Warsh’s economic views don’t appear to line up well with those of the man who is considering hiring him. President Trump is a “dove” who wants lower interest rates to boost economic growth and to lower the interest burden on government debt. Warsh has the demeanor of a “hawk” who says the Fed should focus on keeping inflation down, which tends to mean higher interest rates. This is a potential recipe for conflict should he get the job.
On substance Warsh’s critique has holes.
He accuses the Fed of taking its eye off its inflation mission, but makes no mention of the fact that the Fed codified a 2% inflation target in 2012. The inflation objective has been central to its policy decisions. No interest rate decision was made with climate change in mind. That’s not conjecture; the discussions are laid out in extensive meeting transcripts for anyone to read.
As for diversity and inclusion, history shows that minority populations do well when the Fed meets its goals of low and stable inflation and unemployment. The fact that the Fed has recognized that reality doesn’t necessarily make the central bank woke or distracted.
This isn’t an apology for the Fed. It has made consequential mistakes over two decades of economic turbulence. The financial system nearly collapsed in 2008 with the central bank on the regulatory watch. Then, for a decade between 2012 and 2022, inflation routinely ran below the Fed’s target while unemployment ran high. Then after the COVID crisis, inflation surged, registering its largest increase since the great inflation of the 1970s.
Warsh spends little time examining the economic context in which the central bank acted. Its choices didn’t occur in a vacuum.
The singular economic event of the past quarter century was a China shock, in which the world’s most populous nation became an economic power, flooding the world with cheap products and its own savings. That combination created low inflation and low interest rates for China’s biggest trade partner—the United States.
As far back as 2004, Fed chairman Alan Greenspan expressed bewilderment about the fact that when he raised short-term interest rates, long-term rates fell. Long before the Fed bought U.S. Treasury bonds in its quantitative easing programs, China was buying them, recycling dollars it earned from selling toasters, sneakers, and phones into U.S. debt. It was like a grand dealer financing program that kept interest rates and prices low for U.S. consumers.
China and trade weren’t mentioned in Warsh’s G30 critique of the Fed.
Then, a financial crisis spurred in part by those low interest rates crushed credit and animal spirits. During the decade of the 2010s, U.S. inflation averaged 1.5%, persistently running below the Fed’s 2% target despite its efforts to boost the economy. A decade of persistently low inflation also wasn’t mentioned in Warsh’s Washington speech.
History shows a more hawkish approach would not necessarily have been a winning strategy. During that grinding decade, the European Central Bank initially tried the more conservative approach to interest rates that Warsh seems to have advocated. Its unemployment rate kept rising during its self-imposed austerity while U.S. unemployment slowly fell without causing inflation.
Blaming the Fed
The Powell Fed used tools developed during the long stagnation of the 2010s to address the COVID crisis, slashing interest rates and launching new bond-buying programs. Powell worried he was replaying the 2008 crisis, which resulted in a long period of high unemployment. But this was a much different kind of shock. It hit global supply chains, not domestic credit. It was like taking a hammer to a problem that required a wrench, a serious error of judgment, but not obviously an error of intention or institutional mission creep.
Warsh’s analysis largely ignores that context. At the time of COVID, it’s also worth remembering, he endorsed aggressive Fed action, including a broad lending program to the private sector that he said could be called a “Government-Backed Credit Facility.”
He blames the Fed for enabling large U.S. budget deficits with low interest rates and bond purchases, without holding accountable the elected politicians in both parties who wrote the actual budgets. Imposing responsibility for fiscal policy on the central bank would be exactly the kind of mission-creep that Warsh laments. Its job is supposed to be circumscribed by its inflation and employment mandates.
At another point, Warsh said the Fed never retraced its steps on large bond purchase programs. That isn’t exactly correct. It hasn’t fully retraced its purchases, but the Fed did shrink its holdings from $4.5 trillion to $3.8 trillion after the QE programs of the 2010s, and from $9 trillion to $6.7 trillion more recently. One might disagree with the pace, strategy, or practicality of these steps, but it’s not accurate to say the Fed hasn’t retraced its steps.
The would-be chairman is right that the central bank deserves scrutiny. It has made mistakes with serious consequences for the American people, and he can be applauded for asking tough, critical questions. He also deserves credit for having had the courage to quit the Fed job in 2010 when he disagreed with its choices.
It’s just hard to square his analysis with the Fed’s actual mistakes, and it’s hard to square his stated intentions with the choices the president seems intent to get out of the next central bank leader.
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