Warsh War III: Fighting Groupthink

This is the last part of a three-part series discussing Kevin Warsh’s nomination to lead the Federal Reserve. You can find the first and second parts linked here.

In March 2016, Kevin Warsh addressed the National Association for Business Economics, delivering some pointed criticisms about the Federal Reserve. In his talk, titled “Challenging Guild Groupthink,” he offered a thorough critique of how the Fed approaches monetary policy.

Warsh suggested that there was a concerning consensus among economic forecasts within the Fed. He pointed out that expectations from Federal Open Market Committee (FOMC) participants showed a high degree of uniformity, often aligning closely with staff predictions. This wasn’t merely an academic concern—he felt groupthink was also becoming entrenched among outside economists and Wall Street professionals.

Fast forward five years, and the Fed’s significant missteps regarding inflation seem to validate Warsh’s warnings. Institutions that embraced a more skeptical view on short-term inflation trends likely would have taken action sooner. A less consensus-driven organization, perhaps, would have been more adept at navigating the challenges of the economy following the pandemic.

Fundamental Issues

Warsh’s main concern centers around the Fed’s reliance on certain economic models, which he argues consistently miss the mark. He draws parallels to outdated astronomical beliefs, likening the Fed’s adherence to flawed models to the ancient idea of a geocentric universe, lingering despite increasing evidence to the contrary.

“When reality doesn’t match predictions, the Fed tends to blame external factors,” he remarked. Persistent shortcomings in forecasts have been described as “headwinds,” but he argued that years of such issues suggest a deeper, systemic problem.

Warsh critiques the Fed’s dominant model as a somewhat outdated compromise, systematically overlooking global economic trends and largely ignoring the financial sector. He contends that while no model is perfect—“All economic models are wrong, but some are useful”—the real issue lies in treating model outcomes as definitive truth instead of rough guidelines that should be informed by real-world signals.

The Data Dependency Trap

One term that he believes carries significant risk in Fed communication is “data dependent.” Warsh argues that this notion could be dangerously misleading.

Why, you ask? The data the Fed relies upon can be “anachronistic, outdated, and prone to major revisions.” Reports, like monthly employment figures, can have error margins that make the actual numbers unreliable. For instance, a figure may show job gains of 242,000—but that estimate has a potential deviation of about 100,000 jobs.

Policies influence the economy over long and unpredictable timelines. A wise central banker once told Warsh that “Policymakers often arrive late and should act early.”

Instead of relying exclusively on outdated statistics, Warsh advocates for a focus on market prices, which could provide more immediate insights into the economy. He suggests that monitoring primary commodity prices, especially metals, could lead to improved monetary policy efficacy. The Fed ought to concentrate on significant shifts in economic activity rather than minutiae.

Predictive Failures

Warsh expresses frustration over the Fed’s increasing number of forecasts. Back in 2015, FOMC members generated a staggering array of forecasts and speeches—twice the number given a decade prior.

“What’s driving this jump in predictions?” he questions, highlighting that the Fed has historically failed to predict U.S. recessions in the months leading up to them.

As Paul Samuelson famously stated, “Wall Street indexes have predicted nine out of the last five recessions.” Warsh retorts that this record is still better than the Fed’s history.

The frequent obsession with predictions, he argues, comes with opportunity costs. The Fed’s intellectual resources should be better allocated to address pressing economic challenges, rather than be wasted on models that consistently fail.

From Critic to Chairman

Warsh’s critiques are tied to broader concerns about the Fed’s mission expansion. The central bank has continuously claimed its extraordinary measures would lead to widespread prosperity, yet this hasn’t materialized. The strategies employed, like Quantitative Easing, tend to benefit the wealthy. While those with financial assets saw their wealth grow, a significant portion of American households hold little to no savings.

Warsh’s nomination is often framed as something of a contradiction. Some speculate that, while Trump might have initially favored a more dovish approach, he ended up selecting a hawk instead. However, this perspective oversimplifies the situation, focusing solely on interest rate changes. Warsh emphasizes the importance of real-time market signals, robust discussions, and a cautious approach to monetary guidance.

He also suggests that central banks should steer clear of price increases tied to tariffs, and believes productivity gains can spur economic growth without triggering inflation—challenging traditional views on the relationship between inflation and employment.

Ultimately, the crucial question isn’t whether Warsh is a hawk or a dove but whether his approach can genuinely enhance the Fed’s decision-making. His policies might offer surprises to both the establishment and populist critics alike.