Kevin Warsh spoke — what did we learn? With Torsten Slok

0:00At 8 a.m. Mountain Time on Friday, August 28th, all eyes were on Kevin Walsh, the chairman of the U.S. Federal Reserve. He was opening the Jackson Hole Economic Policy Symposium, an annual gathering of VIPs in the world of monetary policy. The economic backdrop was almost as dramatic as the scenery. Bond yields at 19-year highs, inflation stubbornly above 2%, and a US president clearly keen to keep interest rates low. So, what happened? What did we learn from Walsh's speech? About monetary policy, the path of the US economy, and the global economy?

0:48This is The Economics Show with Zemea Keynes. I'm joined this week by Torsten Slock, Chief Economist at Apollo Global Management, an asset manager with about$1 trillion under management. And I should say that we are recording this at 5pm UK time on Friday, August 28th, or 12pm Eastern time US, just two hours after the Fed chair started delivering his remarks. Torsten, hello. Hello, Samaya. Thank you so much for having me. Okay, so on a scale of 1 to 10, a very precise scale, how important do you think this speech was? So 10 being absolutely pivotal, 1 being completely irrelevant, and just so listeners don't switch off, please don't say 1.

1:33The answer is 10. This was really, really important. He could talk about really anything in this speech, and what he decided to talk about was absolutely critical because there has been a lot of questions around what is Fed communication, what is their goal, what are their instruments. So having more clarity about that and delivering that clarity today was absolutely critical. So this was, on that scale, a very, very important speech today. Okay, so that was higher than I was expecting, but I appreciate your giving people an incentive to listen on. Okay, let's start with a bit more context to people who aren't as immersed in market moves as you are.

2:12Why is now a tricky moment for the Fed? Because the challenge is that the Federal Reserve, just like the Bank of England, just like the ECB, they have a very clear target that inflation should be 2%. The problem is, earlier this week, we got numbers telling us that inflation is not 2%, it's 3.5%. Obviously, it was very high during the pandemic, and it has basically continued to be above the target for a very extensive period. And the key question has been, Is the Fed still required to raise interest rates to get inflation down to 2 %? Or can they just keep interest rates where they are and wait for, popularly speaking, inflation to melt its way down to 2 %?

2:53Okay, there's also been some drama when it comes to communications, right? So Walsh has said he wants the Fed to say less and investors quite like being told what's going on. Whose side are you on in that debate? Do you have some sympathy with Walsh? Yeah, there are some very important nuances in that discussion, because what's being discussed exactly as you're saying, what should the Fed say? There have been a very long period where the consensus basically argued that when interest rates are zero, it's a good idea to say we are going to keep interest rates at zero until, say, the unemployment rate reaches a certain level.

3:32But Kevin Walsh has come in very, very strongly opinionated and said, we no longer need to to give forward guidance, because if you give forward guidance, you are almost promising financial markets and the world that you're going to deliver a certain outcome in terms of what will happen to interest rates going forward. So the first answer to your question is, he has very, very clearly said, we should not be giving forward guidance. Instead, what he has been criticized for, Kevin Walsh, is that people are, of course, now saying, if you don't give forward guidance, well, what is your framework guidance?

4:06In other words, how are you thinking about monetary policy. What are your tools? Are you using interest rates? Are you using the balance sheet? Are you using tighter financial conditions? Those have very different implications for how we think about, in particular, how rates should be trading in financial markets. So the answer to your question is, when the central bank, when the Federal Reserve communicates about how it sees the economy, what it expects in the future, then it does become very important to do this distinction between forward guidance is actually not a good idea. And there, I think he has been treated unfairly because most people actually agree that forward guidance is not a good idea.

4:41But when it comes to framework guidance, most people agree that's a good idea. And this is why the pressure on him going into today was exactly to deliver that. Namely, what is your framework for thinking about monetary policy and interest rates? OK, well, let's get on to the speech itself, which started with a joke. So here's a quick overview of what I'll cover in my remarks this morning. You can call it an outline. You can call it a trail map. But please just don't call it forward guidance. So I guess my next question is on a scale of one to 10, how funny are central banking jokes? Maybe we don't need to answer that.

5:14OK, so to summarize his summary, he covered AI. He covered forward guidance, communication. He covered the principles guiding monetary policy and also his assessment of the economy. So let's just go through those. So first of all, the AI section, which was pretty short, and he mostly just raised a lot of questions as far as I could tell. Will the application of AI cause a significant, sustained rise in productivity across the economy? If so, when? When you find out, let me know. Did you see anything more profound in what he was saying? Or was the point that his views on AI aren't influencing the medium-term outlook because there's just so much that is uncertain?

5:59Well, the reason why this is so important is because if AI dramatically increases productivity, then we will also see a very dramatic decline in inflation. That would also, in the extreme case, involve likely an increase in the unemployment rate. Neither the Fed nor we, not really anyone, really knows exactly what AI will bring along. So the conclusion is that there's just so many open questions around what will AI actually do to the economy that he did not deliver any answers to that debate. Okay, well, that's what's known as Fed speech filler. Okay, well, let's move to the next bit of the speech, which is about communication.

6:38Oversharing policy deliberations and over committing to future decisions can lead markets, businesses and households astray. It feels like there are two kinds of forward guidance here, right? There's the kind where you're basically telling investors, this is what my expectation is of rates. There's an alternative version of it, though, which isn't really forward guidance, as many people would describe it, which is explaining your reaction function, right? Which is explaining if this happens, then I will do that. and arguably, you know, some of the forecasts that the Fed puts out in the form of the dot plot, as it's known, you know, they are conditional forecasts.

7:20They're saying if economic conditions proceed in the way that we expect, this is roughly where we think interest rates will be. And it feels sometimes like Walsh is sort of confusing the two. And so he's being critical of forward guidance in the first form, which many people are. But he's then saying, I don't want to give any guidance of the second form, which people are getting much more frustrated by. Do you think that there was any flavor of that sort of disagreement, those two different kinds of guidance in his speech? You're right, because there has been a very important debate around forward guidance is indeed not helpful for the central bank, because it eliminates flexibility for the Fed to do something differently in the future.

8:02and it locks in what expectations are to where interest rates will be in the next 6 to 12 months. So that's why his emphasis was really more on providing more clarity, exactly as you say, on the second part, namely what, popularly speaking, is, of course, the description of the reaction function or what, of course, some people also call framework guidance. So let's say, for example, inflation begins to go up for whatever reason. It could be because you had restrictions on immigration. It could be because of oil prices going up in the Middle East. What is your thinking around those types of shocks?

8:35Do you think these shocks are enough to warrant a reaction? Do you think these shocks are temporary? Do you think these shocks are minor? How do you quantify the impact of these shocks? And those deliberations, we did get some more clarity about today, especially the most important point, namely, what is the tool that you would be using if you think that inflation is too high? Because even this has been associated with some uncertainty. because historically, Kevin Walsh has been very well known for having strong opinions about that the Federal Reserve needs a smaller balance sheet. And today he made very clear that the number one tool for solving any inflation problem is interest rates, not tighter financial conditions and not the balance sheet.

9:16So in that sense, the answer to your question is, he still distanced himself very clearly from forward guidance, but he made more clear how the framework works. And most importantly, he made clear that the main tool they have is interest rates. OK, so let's move on to the next bit of the speech where he was talking about the principles of monetary policy. And he was really trying to make it clear that he does care about inflation. He wants it to get to two. Price stability is not self-executing, nor is inflation necessarily mean reverting. It's the Fed's job to deliver stable prices. Right. So this clearly seemed like a message to investors.

9:56You know, don't doubt me. I'm going to get to two. Do you think it was enough? Here is also a very, very important difference between the Federal Reserve and the Bank of England and the ECB. The Bank of England and the ECB have one goal and one goal only, namely inflation at 2%. The Federal Reserve has two goals or dual mandate, as it's called, namely inflation at 2 % and full employment. And in that sense, what was a bit unclear going into the speech today was, well, how does Kevin Walsh balance these two goals? And what came out of the speech today, which is why it's also very critical, he did put a lot of weight on inflation.

10:34In other words, it almost seemed like he was changing the weights on inflation relative to unemployment, saying, I think inflation is the most important thing now. And it makes sense to say that when inflation today is three and a half percent and it should be two percent. That means that he did emphasize guys, we got to have inflation come down. And therefore, we are ready to hike rates if we want inflation to come down. And that's why, of course, after the speech, financial markets are now pricing that we will get a hike already at the next meeting in September. That was not the expectation going into the speech.

11:06The expectation in markets pricing was that the hike would come in December. So in that sense, he pulled forward. He made it a much more immediate decision that the Fed will probably be raising interest rates in the next meeting in September. So now the only key bottom line here is that was the words. And this is why what really, of course, is critical now is whether those words are followed up by action at the next meeting. Yeah, after the July press conference, I think there was some question about whether he was going to try to get the markets to do his dirty work for him. There's a sense that, you know, if you just signal that you're going to raise rates, maybe financial conditions will tighten.

11:43And, you know, that could pull inflation down, meaning that the central bank doesn't have to follow through and actually raise rates. And what he seemed to be saying today was, no, no, no, I do believe that you do actually have to raise rates. Although, as you say, we'll see what happens. OK, I want to throw to a break now. And when we get back, I want to talk about the thing that Walsh didn't mention in his speech, which is what is going on with US government debt.

12:25We'll see you next time.

12:44win and Franks win. Lenders win and so do Lindas. When you build credit scores the right way, everybody wins. Get started at VantageScore.com.

12:57We are back from the break. Okay. So some context we didn't mention earlier is that Scott Besant, US Treasury Secretary, has been intervening in the US Treasuries market, which has created this tension. Because on the one hand, you've got the Fed chair, Kevin Walsh, saying, I want the pure market signals. I just want to find out what the magical markets think about prices. But on the other hand, we've got Scott Besson, the US Treasury Secretary, saying, no, no, no, markets are wrong. Yields are too high. We're going to intervene to try and fix that. It feels like these two guys and not work together.

13:39What is your take? Yeah, it does say, you're right. It does look a little peculiar that Kevin Walsh on the one hand has said, I want unfiltered signals from the market. And then suddenly, literally a few weeks later, then Scott Besson decides to say, well, the market is wrong. So now we're going to intervene. And he really decided to intervene in three different ways. First, he did the yen intervention, which was done with a very important goal of trying to prevent sales of US treasuries by the biggest holder, the Japanese investors. So first, the yen intervention was one way to try to control long-term interest rates.

14:14Then we had the FEMA or the buyback decision from two to four billion, relatively small numbers, but still very important signal. And now we had some discussion also earlier this week about the treasury general account potentially, which is about almost a trillion dollars, which potentially also could be a tool to try to limit how much long-term interest rates go up. So you're right, Scott Besson has been trying to manage long-term interest rates in different ways. and trying to signal to financial markets that he thought long-term interest rates were not trading at the right level, while at the same time, Kevin Walsh has been saying that he just wants the unfiltered level of long-term interest rates.

14:47And that does indeed seem to be a bit of conflict. Do you think that this incoherence or this tension between the Fed and the Treasury will be resolved anytime soon? Well, we also had Stan Druckenmiller earlier this week, also who, of course, is the mentor for both Walsh and for Besson. He wrote an op-ed in the Wall Street Journal basically saying that he thought that the interventions were not going to be successful. And instead, he was basically saying politicians on Capitol Hill should address much more directly head on the fiscal problems in the US. So I think that the tensions not only between these three individuals, but the tension in markets is really important at the moment.

15:29maybe trying to figure out what is the fiscal outlook for the US? What's the fiscal outlook for that matter for the UK, for France, for Japan? And in the middle of this stands the Federal Reserve, and to some degree also Scott Besson, trying to manage this difficult situation where really nothing is being done about the fiscal outlook. They've really been dealt some bad cards that they're trying to play as good as they can. Yeah, I mean, my prediction is that the politicians are going to do a big, fat, sweet nothing about the fiscal position. And so, you know, these tensions are going to continue.

16:02What happens if Scott Besson intervenes some more in the Treasury's market? Yeah, the way the intervention was done was simply by buying the long end of the yield curve, which, of course, is an attempt to try to get long-term interest rates to go down, and instead issue more bonds in the front end of the yield curve, which is essentially a different way of saying increasing the amount of debt outstanding in the very front end, in particular in T-bills. And by issuing more T-bills, at the moment, the share of government debt outstanding in the US, that is T-bills, is roughly around 23%. And if that begins to go up further, that means that when short-term interest rates suddenly are now set by the Federal Reserve and at risk of going up, that means, of course, that the debt servicing cost will also be going up if a larger share of government debt is in the very front end of the yield curve.

16:53So the challenge at the moment is that the Treasury is making itself more vulnerable to what the Fed is deciding to do with short-term interest rates. And that is a challenge, not a big issue, but if this trend does continue for several quarters and in the worst case for several years, it of course continues to make government debt payments more and more and more sensitive to what the Federal Reserve decides to do with interest rates. Okay, so by swapping long-term debt for short-term debt, you become more sensitive to short-term interest rates. So, you know, don't expect a US president to become any more relaxed than they are already.

17:31And the very interesting part of this discussion also, in particular from a UK perspective, is that it was the case that in the British situation, debt was historically very, very long dated for the government. But in the last five years, that has been shrinking dramatically. So now more and more debt is in the front end of the yield curve, which is creating not quite the same type of problems we have in the US, but it's creating a similar challenge that debt servicing costs will suddenly become more sensitive to what does the MPC, or in this case, the FOMC, decide to do with interest rates. So that's why there used to be very, very strong separation between monetary policy and fiscal policy.

18:07But the link between these two has just become more intimate, especially in the last few years. Okay, so it sounds like Kevin Walsh might have quelled the drama today, but there will be much more to come. Torsten, thank you so much for joining me. Thank you.

18:34That is all for this week. You have been listening to The Economics Show with Samaya Keynes. If you enjoy the show, then I would be eternally grateful if you could rate and review us wherever you listen. And if you love listening to The Economics Show, join me on Saturday, September 5th at Kenwood House Gardens in London or online for the FT Weekend Festival, where I'll be talking about my recent book, How to Win a Trade War. Register now at ft.com forward slash festival and enjoy 10 % off with code FT podcast. I've left a link in the show notes. This episode was produced by Sonia Hudson and Misha Frankel Duval with original music from Breen Turner and sound design from Samantha Jovinko.

19:21Our executive producer was Tofa Forges. I'm Sumaya Keynes. Thanks for listening.

19:53and alternative data than legacy models, bringing more people into the credit economy, like 5 million more mortgage-eligible people. Banks win and francs win, lenders win, and so do lenders. When you build credit scores the right way, everybody wins. Get started at VantageScore.com. The new episode of the Next 5 podcast is all about sovereignty, data, and control. Charlie Giancarlo at Everpure joins me. You always get a very embarrassed response if you ask them if they know where all their data is. as does Professor Sana Karaghani. There isn't any modern AI system that's entirely sovereign. And Claire Schramm-Fergus at Lloyds Banking Group.

20:33We really need to design for safety rather than bolting it on at the end. Listen to The Next Five wherever you get your podcasts. Enjoy.