The writer, professor of economics and finance at Columbia University, served as chairman of the American Council of Economic Advisers under President George W. Bush.
Donald Trump’s appointment of Kevin Warsh as chairman of the Federal Reserve comes at a crucial time for the US economy and for the US central bank. A shadow has been cast by the administration’s unforced error with the trumped-up charges against Jay Powell, the current Fed chairman, and the president’s renewed threats to fire him if he does not leave before the end of his term. But the nominee’s references and experience must guarantee a smooth confirmation. The question now should be what happens next.
The Fed faces three challenges. In the short term, the potential impact of the Iran war on employment calls for a careful assessment of the direction of the U.S. economy. In the medium term, continued inflation above the 2 percent target will limit the central bank’s room for maneuver and also call into question its credibility. Longer term, questions remain about the effectiveness of quantitative easing, the size of the Fed’s balance sheet, the mistakes made in the wake of the Covid pandemic, and the central bank’s forays into areas better left to fiscal or regulatory policy.
All this means that when Warsh eventually takes the post, he must immediately launch a review of the Fed’s purpose, strategy and structure.
First: purpose. The Federal Reserve was created as a last resort to alleviate financial crises. After struggling to fill that role during the Great Depression, it turned to controlling aggregate demand and inflation. In 1978, Congress used the Humphrey-Hawkins Act to codify its focus on inflation and employment while giving the Fed latitude to achieve these goals. It also required the Fed chairman to report to Congress on results and prospects.
Warsh should now provide a justification for each of these objectives, clearly outlining the trade-offs they entail and how progress will be communicated. This clarity focuses markets and elected officials on the importance of low and steady inflation to U.S. economic performance. And the arrival of a new chairman offers an opportunity to make decision-making about the Fed’s lender of last resort clearer. Such explanations would be useful in the current environment of economic and public policy uncertainty.
Next comes the strategy. This involves choosing a set of activities that consistently deliver objectives. For the Fed, the independence of monetary policy and the ability to ease the balance sheet allow the Fed to keep inflation low and manage financial turmoil. Political attacks on the country’s independence, of the type we have recently seen, or restrictions on the country’s balance sheet as a lender of last resort jeopardize these strategic advantages.
To realize its purpose and strategy, the new chairman must optimize the Fed’s structure. The arrangement of a board of governors in Washington, district banks headed by district presidents, a Federal Open Market Committee of the board and (a rotation of) five district presidents is established by law. But there are three practical steps Warsh could take to improve the effectiveness of this setup.
First, the central bank should cast a wider net to gather insights from economists, business leaders and financial market participants, reopening Fed conferences to members of these communities. Second, decisions and directives must be consistently communicated to the financial markets and the public by the chairman and other officials.
Third, replace the infamous “dot plots,” which plot FOMC members’ projections for the federal funds rate, with scenarios. Dot plots can be misinterpreted as signals about the future path of interest rates. Scenario analysis, on the other hand, models how policies would respond to major changes, such as shifts in AI investments, supply constraints, the natural rate of unemployment, and the medium-term effects on inflation, the dollar, and U.S. economic activity resulting from the conflict in Iran.
Such a comprehensive review of purpose, strategy, and structure would provide Warsh and the Fed with both renewed organizational cohesion—and, more importantly, a game plan.
On the perennial issue of interest rates, the short-term momentum of the US economy and high inflation are likely to tilt risks toward further cuts, despite Trump’s enthusiasm for an immediate cut. And while Warsh is right to point out that the Fed needs to learn more about the economic effects of AI, an economy with high productivity growth is associated with higher, not lower, real interest rates over the medium term.
During this crucial period, the new President’s ability to clearly communicate the value of low and steady inflation to the public will be critical. The rules for the Fed’s role as lender of last resort also need to be made clearer. Finally, Warsh is right when he says that the Fed needs to make sure it doesn’t pursue the kind of backdoor fiscal policies it has pursued in recent years.
Warsh is smart, informed, experienced in crisis management and an excellent communicator. If the president gives him a free hand as chairman, the American economy should reap the benefits. Stay informed.
