The idea that Kevin Warsh can raise his own credibility by raising the funds rate continues to gain popularity among the “edgy.” But it is a very weird claim.
For starters, the credibility gained here would presumably be mostly among capital market participants, who focus on the symbolism of policy innovations. But the inflation expectations in the bond market, at horizons that relate to credibility, as opposed to the cycle (or Iran), are already fully consistent with the Fed hitting its 2% inflation target, which was dutifully reiterated in the most recent report to Congress. So, it is not at all obvious, what is to be achieved there. Would it be better if people expected the Fed to undershoot? Would that raise Warsh’s credibility?
But if there is no problem to solve in the capital markets, maybe this is about Warsh raising rates to establish his own stature, which is I guess a slightly different thing. But why would raising the funds rate as a stunt improve his credibility? I concede there is one way it might. If most people did not view it as the stunt that the edgy folks have identified, then I guess that might work. It would be a pretty clear expression of the Greater Fool theory, though. Warsh would raise rates because he knows it is a stunt, but he would figure that other people — including this colleagues on the FOMC — could not figure out the same point. I guess that is possible. Seems a dubious base case.
Sorry to lack edge, but the best way for Warsh to raise his credibility is to deliver the right policy. He insists on that point himself, although with a bit more grandiosity than is to my taste. It is easily conceivable that the non-stunt case for a rate hike tomorrow would actually have merit, although we would know that only in the fullness of time. The demand side looks solid and inflation is meaningfully above target, despite the one month of relief we saw in June.
However, there is another more serious “credibility” consideration that actually operates in the opposite direction, though. The Fed seems (to me) to be influenced by the common view that frequent directional changes in the path of the funds rate would suggest that the Fed is unsure of itself. And the Fed’s apparent deference to this position reinforces that same position, as part of a positive feedback loop. So, in the event that the objective case is debatable, that tie or even near tie probably goes to policy inertia.
Or in English, people believe that the Fed believes that the odds have to be above even that a policy change will not need to be reversed before making it. I would guess that this is the salient credibility issue here. And it is embedded in pricing and in my own sense of what the Fed will be inclined to do.
