Warsh’s Fed Is Closer to the ECB Than You Might Think
The new chair’s focus on price stability brings the Fed closer to the eurozone’s monetary policy approach. A commentary by Lorenzo Bini Smaghi
The Federal Reserve, meeting for the first time under the leadership of Kevin Warsh, appointed by President Donald Trump after prolonged attacks on his predecessor Jerome Powell, has decided not to raise interest rates.
At first sight, the decision may appear to mark a significant divergence from that of the European Central Bank, which had raised rates by 25 basis points a week earlier.
In reality, the difference is largely explained by the different starting point. Although inflation forecasts are fairly similar for the United States and the eurozone, at 3.6 per cent and 3.0 per cent respectively for the current year, and 2.3 per cent for both in 2027, the policy rate in Europe stood at 2 per cent, compared with 3.5-3.75 per cent in the US.
Adjusted for inflation expectations, the European rate remains well below the American one. Monetary policy is therefore more accommodative in Europe, even taking into account the lower expected growth rate.
Warsh’s first statements also point to a degree of convergence with the European monetary policy approach. He made clear that, although the Federal Reserve’s statutes give it a dual mandate, price stability and maximum employment, the central bank’s responsibility is to ensure price stability. This is defined as an increase in the price level of 2 per cent. No European central banker would have said it differently.
This marks a change in tone from his predecessor, who had explained in the past how the Federal Reserve’s dual mandate involved complex choices, especially in the case of asymmetric shocks such as an increase in energy commodity prices, which push inflation up while depressing the real economy. That had led some market participants to believe that the central bank would tolerate higher inflation in order not to slow growth.
Another, more important, change is the decision to stop giving markets guidance on the future path of interest rates. Under the procedures used so far by the US central bank, each member of the monetary policy committee made public his or her forecast for interest rates in the months ahead (the so-called dots). The aim was to make the decision-making process more transparent and to guide market expectations.
Warsh decided to end this practice, the so-called forward guidance. Given the uncertainty and the continuous changes in underlying economic conditions, central bank guidance on future interest rates risks becoming quickly obsolete and misleading markets.
It is better for financial markets to produce their own forecasts independently, based on their assessment of the underlying economic data and on the central bank’s reaction function, whose objective is price stability.
The ECB already abandoned the practice of guiding markets some time ago, after it proved not very effective and reduced room for manoeuvre, especially in the event of an unexpected change in the outlook.
Some market participants and some academics will be disappointed, having grown used to receiving extensive indications from the central bank on the future evolution of rates. This may produce greater market volatility, but it will also improve the ability of markets to signal its own expectations.
Kevin Warsh has also announced a series of initiatives to review several aspects of the monetary policy strategy. Five task forces will be set up to assess issues relating to the size of the balance sheet, communication, statistical collection and the impact of artificial intelligence, especially on inflation.
What is distinctive about these initiatives is the involvement of external experts, possibly holding different views, with the aim of highlighting the pros and cons of the various options in an open and transparent way.
The work of the group examining the central bank’s balance sheet will be particularly important.
Warsh has in the past expressed rather critical views on the central bank’s asset purchases, which had expanded the balance sheet excessively. He has nonetheless requested the working group to examine the risks and benefits of the current system, which produces an excess of bank reserves, as well as alternative mechanisms of monetary regulation.
This appears to signal pragmatism and a willingness to reconsider his own positions on the basis of rigorous analysis.
It is an example to be followed if central banks don’t want to be perceived as ivory towers.
A previous version of this article was published in the Italian daily Il Foglio
IEP Bocconi does not express opinions of its own. The opinions expressed in this publication are those of the authors. Any errors or omissions are the responsibility of the authors.
