A Little Volatility Might Be Just What the Fed Needs
“When someone shows you who they are, believe them the first time,” is a popular idea attributed to poet Maya Angelou.
While Angelou wasn’t addressing monetary policy directly, her words do resonate when considering Kevin Warsh’s time at the Federal Reserve. A corollary is that to be taken seriously, one must demonstrate who they really are.
Warsh has expressed his desire to shift how markets and investors react to economic data and Fed communications. Specifically, he’s advocating for greater focus on economic conditions rather than Fed statements. That’s his stance, but he hasn’t yet fully revealed his approach.
This is crucial since Wall Street seems very confident that the Federal Reserve is unlikely to raise interest rates in the upcoming meeting. According to CME’s FedWatch tool, investors believe there’s only a 10 to 15 percent chance of a quarter-point increase.
Those odds seem not quite right.
The argument for another rate hike is clear. Inflation continues to run well above the Fed’s goals and appears to be gaining traction. Oil and gasoline prices are high, and there’s no end in sight for the conflict in Iran. Consequently, inflation is likely to stay beyond the Fed’s comfort level. Worse yet, there are indications that inflation is spreading beyond just oil into the wider economy. So, maintaining price stability is a significant challenge for the Fed.
In contrast, other areas of the Fed’s responsibilities are performing well. Initial jobless claims are at remarkably low levels, and the unemployment rate, which was at 4.2 percent in September, suggests we might be nearing full employment. The burgeoning AI investment sector is drawing huge amounts of capital, stock prices remain close to all-time highs, and S&P Global’s October purchasing managers’ surveys reflect a booming economy, possibly growing at around five percent.
Some Fed officials who are inclined to keep rates steady at this week’s meeting still anticipate another hike in December. So, why not act in December? The next Fed meeting is only about six weeks away. In that time, there will be two monthly employment reports but only one additional inflation report and one month of PCE data after September. The November CPI won’t be released until December 10, which is right after the Fed makes its decision. If officials think a hike is warranted now, what are they really waiting to find out?
Moreover, there are factors that might encourage Fed Chair Kevin Warsh to support a rate increase that go beyond immediate economic indicators. A hike would enhance his credibility in tackling inflation. It could also signal his independence from President Trump and show that he is steering the Fed, not merely following a three-headed leadership team with New York Fed President John Williams and Vice Chairman Philip Jefferson. Additionally, it may set boundaries for some Fed officials who feel compelled to publicly predict the Fed’s next actions.
Some have suggested that the Fed would avoid raising rates so close to the midterm elections. Historically, this hasn’t been the case, though; the Fed did raise rates around elections in 1978, 1982, 2018, and 2022. And, a second hike is less controversial than initiating a new cycle of hikes or cuts right before an election. Besides, the political fallout might be minimal. President Trump generally supports lower rates, but he might back a hike in the federal funds rate if it lowers long-term mortgage and debt rates, due to increased trust that the Fed will manage inflation effectively. Many conservative commentators have already hinted that a rate hike could be seen as justified. Warsh enjoys enough support on the right that a hike is unlikely to be viewed as a politically motivated move against Trump.
More importantly, this move would indicate that Warsh truly intends to move away from forward guidance. Every meeting is supposed to be a live event. Yet investors have convinced themselves that Wednesday’s outcome is virtually predetermined.
A hike would swiftly change that narrative.
The Trouble with Tranquility
The primary argument against raising rates this Wednesday is that the markets aren’t prepared for it.
In the Monday issue of the Wall Street Journal, Nick Timiraos cites former Dallas Fed President Robert Kaplan, who has said that officials have not sufficiently prepared investors for a rate increase. Kaplan also expresses concern about the potential market disruptions, claiming “there’s a cost to creating undue volatility.”
Former Fed Vice Chairman Alan Blinder echoed this sentiment in a Sunday Journal article. He reminisced about the “bad old days” when markets would sometimes misjudge Fed decisions, resulting in what he calls “excess volatility.”
The term “excess volatility” seems somewhat presumptive. Blinder suggests he knows the ideal level of volatility, even though he doesn’t clarify how he has arrived at that conclusion. It seems to him that having less volatility is surely better than having more.
However, the more pressing problem might actually be low volatility. After years of policies designed to minimize financial fluctuations, particularly in the bond market, there’s a risk that investors have become overly complacent.
This situation is often referred to as the “volatility paradox.” Lengthy stretches of calm can prompt investors to take on more risk, lower their protective measures, and adopt trading methods that become perilously vulnerable when volatility inevitably returns.
This concept is not new. Economist Hyman Minsky famously stated that too much stability can be destabilizing. When financial markets stay calm over extended periods, it leads investors and businesses to believe that good times will persist. This overconfidence can cause businesses to incur more debt, take greater risks, and create financial strategies that rely on ongoing stability. We’ve seen this play out before: the financial system can become precariously fragile simply because everyone has become too comfortable with what seems like safety. (Economists Markus Brunnermeier and Yuliy Sannikov developed a formal model of this paradox in a 2014 paper.)
In essence, the seeming safety of stable markets can increase the overall risk in the financial system. A little volatility now may prevent a lot more chaos later.
Warsh has long recognized this. In a 2008 speech, he remarked, “Volatility is generally a friend, not a foe, of market functioning.”
He continued by arguing that market movements should be allowed to influence the financial landscape, as long as they don’t create instability.
His perspective doesn’t seem typical of someone who would hesitate to raise rates due to potential market turmoil.
Who’s the Boss?
Warsh has consistently indicated that he prefers investors to focus on economic fundamentals instead of trying to decipher the Fed’s intentions. He also aims for market prices to convey independent information to policymakers.
Nevertheless, the market’s strong belief in a pause in October seems to hinge significantly on what Fed officials have indicated about future actions. Timiraos pointed out that market expectations have been shaped as much by Fed communications as by actual economic conditions.
Now, these same expectations are being used to argue against a rate hike.
It’s almost impressive, in a way, that Wall Street has transformed its own projections into a rationale for why the Federal Reserve should follow its lead.
We’re not suggesting that a rate hike is a certainty this week. But if the economic indicators justify higher rates, the potential for unsettling investors probably won’t be a major hurdle for Warsh. A bit of volatility might be just what the markets need to remind themselves that the Fed doesn’t operate by guaranteeing its forecasts.
Warsh has shared his vision with investors. Perhaps he’s now on the verge of putting that vision into action.
