‘Honeymoon’s Over’: Warsh Under Pressure as Fed Weighs Raising Rates

Three years before taking over as chairman of the Federal Reserve, Kevin M. Warsh recounted an exchange he once had with a hero of his, Paul A. Volcker, the celebrated central banker.

Mr. Volcker, who navigated the Fed through one of the worst bouts of inflation in the 1970s and 1980s, told Mr. Warsh, then a governor, that the central bank’s job boiled down to two primary responsibilities. The first was getting interest rates “about right.” The second was to “make sure you look like you know what you’re doing.”

Those duties are top of mind as Mr. Warsh prepares for his first address as chairman to the world’s leading economic policymakers in Jackson, Wyo. His speech, scheduled for Friday at 10 a.m. Eastern, is the biggest draw of the three-day conference hosted by the Federal Reserve Bank of Kansas City.

It will offer Mr. Warsh the most powerful perch yet to articulate his own framework for thinking about the economy, the policy choices in front of the Fed as it contends with elevated inflation and how he is blockessing seismic changes — such as new sources of productivity gains from artificial intelligence — that could alter the country’s growth prospects in the years ahead.

Those details have been intentionally sparse, reflecting Mr. Warsh’s inclination to guard his preferences. One of the only things that Mr. Warsh has made unequivocally clear is that he is committed to getting inflation down after five years of the central bank’s overshooting its 2 percent target. And even then, he has spoken only obliquely about the possibility of raising rates to get there.

The lack of specifics on where Mr. Warsh stands on a number of fundamental issues has caused confusion both inside and outside the Fed, overshadowing his broader ambitions to enact sweeping change at the institution. Resolving this does not require Mr. Warsh to provide specific guidance about the Fed’s policy moves in September and beyond, as he is staunchly opposed to doing. But a slight change of tack is required to begin to reset the narrative after a rocky start.

“You won’t accomplish anything if you are unwilling to tell people how you think the economy works,” said Anil Kashyap, an economist at the University of Chicago’s Booth School of Business. “You have to have a mechanism that you think explains why if you’re going to do something differently, it’s going to turn out better. And that means you need to pick a lane on various issues.”

“The honeymoon’s over,” Mr. Kashyap added.

Big Picture Versus ‘Here and Now’

Going into this year’s conference, Mr. Warsh seemed inclined to give what he described last month as a “big-picture speech” that would tackle structural shifts afoot that could alter how the Fed sets policy in three or four years’ time.

Such an approach would have aligned with Mr. Warsh’s frequent criticism that officials often get “caught up in the myopic” of near-term rate decisions, putting too much emphasis on monthly fluctuations in economic data that is often subject to large revisions. It would have also placed at the forefront the work of the five task forces that he convened to look into a range of issues, from how the Fed communicates to the optimal size of its balance sheet.

Mr. Warsh will no doubt highlight on Friday the ongoing efforts of these task forces, whose work is set to wrap up by the end of the year. But the current backdrop demands some commentary on the present, said Richard Clarida, a former Fed vice chair now at PIMCO.

“Monetary policy is also about the here and now,” he said.

The “here and now” for Mr. Warsh has become much more complicated in recent weeks. Long-term U.S. borrowing costs have surged to multidecade highs, prompting surprise interventions from Treasury Secretary Scott Bessent to stem the rout. Traders are now testing Mr. Bessent’s resolve, leaving markets on the whole more jittery.

At the most basic level, Mr. Bessent has raised the stakes for Mr. Warsh this week, according to Michael Strain, an economist at the conservative American Enterprise Institute.

“It makes it more important than it already was that Chairman Warsh clearly communicates his views of how the economy works, the trade-offs that the economy faces and the Fed’s role in markets,” he said. “The risk of a lack of clarity is an increase in financial market volatility and an erosion in the credibility of U.S. institutions.”

A ‘Generational Reset’ in Rates

Mr. Warsh places significant value on market signals.

In fact, the main justification for his saying so little to this point is that he wants a cleaner read on how incoming data and other developments are being digested, rather than having the Fed’s own views reflected back to officials. It is also part of why he wants the Fed to maintain a smaller balance sheet. The central bank, having established a large footprint in markets by snapping up government bonds and mortgage-backed securities during past crises, has distorted the process of how financial blockets are priced, Mr. Warsh has argued.

Mr. Bessent’s recent interventions have made market signals all the harder to discern, yet there are still clear takeaways for Mr. Warsh that are going to shape his thinking about the outlook.

What is taking place, according to Mr. Clarida, is a “generational reset in bond yields.” This is being driven by a multitude of factors, ranging from a worsening fiscal situation as the United States continues to borrow heavily to heightened policy uncertainty. That has materialized in the form of what’s known as a higher “term premium,” which is the compensation that investors demand to hold long-term securities over short-term ones.

Another driver is the ongoing boom in A.I. investment and the stronger growth that it might usher in, something Mr. Warsh does not want to snuff out.

“The trend is our friend here,” he said at a congressional hearing last month when asked about the general uptick in business capital investment.

Mr. Warsh remains hopeful that broadening A.I. use is going to translate to higher productivity, even if in the meantime the surge in spending is raising prices on a number of crucial inputs, such as computer chips and semiconductors. More investment has also translated to higher rates as technology companies embark on aggressive borrowing to fund their growth, said Jean Boivin, a former deputy governor at the Bank of Canada who is now head of the BlackRock Investment Institute. All of that added supply has eaten into the demand for Treasuries.

Rather than having productivity gains lead to disinflation and in turn lower rates, as Mr. Warsh has argued, “if all the investment is justified, then we’re going to see more of a story about competition for capital and higher rates,” Mr. Boivin said.

A.I. optimism has collided with pessimism about the Iran war, which appears far from resolved. The protracted conflict has already raised overall inflation, and the longer it drags on, the more likely it is that other price pressures acblockulate such that the Fed is forced to respond with higher rates, economists warn. The same is true for President Trump’s tariffs, whose impact on consumer prices was finally starting to fade after a flurry of tariffs last year. A new trade war with Canada now threatens to revive those concerns.

At a Crossroads

This constellation of risks puts the Fed at a difficult crossroads. Inflation has moved farther away from the Fed’s target this year, and there are credible reasons to think that it is not going to retreat to 2 percent in a timely fashion without some tightening of the central bank’s policy settings.

Several officials have already embraced the need to raise rates. This cohort does not believe that rates at the current range of 3.5 percent to 3.75 percent are inflicting any constraint on economic activity. Financial conditions, which track the availability of credit across the economy, also do not look particularly tight, they say. With multiple sources of price pressures, they argue that the prudent path forward is for the Fed to raise rates gradually now. That way it avoids the need to play catch-up later with much more aggressive, and likely painful, moves if either inflation reaccelerates or the public begins to lose confidence in the Fed’s resolve to bring it down.

Still, a majority of officials have yet to abandon their forecast that inflation is set to decelerate in the latter half of the year. They maintain that the central bank can afford to be patient and see how the economy evolves before taking action. Data over the past two months have given this view credence, but it is predicated on there being continued progress. If inflation does not soon decelerate, these policymakers have said they will be ready to raise rates.

That approach is one that Mr. Warsh is unlikely to oppose, given his long history of worrying about inflation. But his no-guidance approach has limited his ability to state that plainly. Markets, left to parse obscure messages, have started to question Mr. Warsh’s willingness to follow through when the administration is clearly worried about borrowing costs and affordability challenges for Americans ahead of the midterms.

“Earlier this summer, the market felt more confident that the Fed would walk the walk — now, there is some slight jitteriness that the perceived hawkishness from Warsh was more about talking the talk,” said Deirdre Dunn, head of global rates at Citigroup.

The decision before Mr. Warsh ultimately comes down to how confident he feels that inflation eases without some nudge from the central bank. His reputation, which he staked on vanquishing inflation once and for all, depends on getting it right.

The problem is that the outcome could hinge in large part on the “what-ifs” — the unforeseen shocks that are out of the central bank’s control — warned Ellen Zentner, chief economic strategist of Morgan Stanley Wealth Management. In the last six years, the Fed has had to contend with a pandemic, Russia’s invasion of Ukraine, a global trade war and now a protracted conflict with Iran. All of those shocks made the Fed’s inflation problem more intractable.

“If those ‘what-ifs’ change the trajectory for inflation, then the Fed has to change their thinking about the appropriate setting of monetary policy,” Ms. Zentner said.