I want to start this month by expressing my sadness at the passing of Jim Leaviss. I did not know Jim personally but his views on macro and markets, and his passion for music and football suggest that he and I would probably have got on pretty well. I always saw him as a bit of a kindred spirit and thus it shocked and saddened me to learn that he had passed so young.

Jim’s taste in music was eclectic and credible, mine is pretty broad (our tastes intersect significantly here - LCD Soundsystem - All My Friends (Glastonbury 2024.) I think he too would have been a little embarrassed about anchoring a commentary around lyrics from a Boyzone song. But there we are. That is what I have done.

Kevin Warsh, the new Chair of the Federal Reserve (the Fed), is causing quite a stir among bond investors, market-watchers, former central bankers, commentators and journalists.

Mr Warsh is critical of the way that the Fed operated under previous leadership. This critique is long-standing. Indeed, it goes all the way back to his previous tenure at the institution between 2006 and 2011. There are several aspects to his criticism. One is that unorthodox policy tools, which may be appropriate for short periods during crises, have been used too much and too often. This has resulted in a balance sheet which is unnecessarily large and is distorting financial markets and their ability or willingness to appropriately price risk. I agree wholeheartedly with this view. There is much evidence to support the notion but one of the most significant effects – which is both hiding in plain sight and incredibly dangerous in the long term – is the extent to which the Fed’s holdings of US government bonds have permitted a bi-partisan irresponsibility with respect to fiscal policy. Treasury yields have been artificially supressed for many, many years and this has seriously curtailed the market’s ability to influence fiscal policy via treasury prices and yields.

He has other concerns, which relate to matters such as data quality and the fundamental notion of what exactly inflation is and which aspects of it should drive monetary policy changes. These are also questions I think are entirely valid and I wholeheartedly welcome his attempts to investigate and improve Fed decision making.

It seems to me that much of the public pushback is driven by academics who consistently fail to see how badly their half-baked theories translate into reality. Many other critics are commentators and market participants who have become arbitrarily attached to the status quo ante. They seem to believe it to be credible or optimal simply because it is what has been done before. Neither of these are a genuine basis to oppose a rethink. By setting up taskforces, populated with credible, independent thinkers from outside the Fed’s machinery, Mr Warsh is embracing potential change in an open, honest and objective way. This should be applauded, not sneered at.

However, the big change Mr Warsh has already begun to implement, and which is causing the bulk of the proliferation of furious column inches, relates to communication. This is the aspect I want to focus on today.

Let us first specify some key definitions and justifications for the pre-existing consensus with respect to central bank communication.

In its most basic and long-standing form, central banks have embraced communicative openness and transparency for one key reason. They are basically providing consumers, producers and market participants with an accurate mental model of how the central bank in question will weigh up the various economic variables that will dictate growth, employment and inflation over the medium term. This will allow markets to appropriately imbibe and parse incoming economic data in such a way as to price future interest rate changes in much the same way as the central bank would/will. This should make transitions between monetary policy changes smoother and thus reduce unnecessary volatility in market pricing. This is a valid notion in theory. Alas in practice it runs into some pretty critical roadblocks.

Firstly, modern central banks are more democracy than autocracy. In years gone by, either explicitly (Reserve Bank of New Zealand) or implicitly (the Fed under Alan Greenspan) there was a powerful decision-maker at the helm. Understand their view and you would understand the institution. Nowadays that approach is deemed undesirable. Instead, the favoured approach is a committee of diverse thinkers who are less prone to individual errors of logic or understanding. Much the same evolution has taken place in professional fund management. Whether that has led to better results in either field is a question for another day. Thus, understanding the institutional reaction function is very hard. Instead, what markets are wont to do is to reprice a little every time we hear from an individual policy maker. Whether they be hawks or doves, economists or lawyers, political or not. Or indeed whether they have a strong, robust track record of making accurate or valid assessments of the economic landscape. In each case, the speaker presents their own individual version of events, their own individual forecasts and expectations and their own individual reaction function to these potential outcomes. Practically speaking we are bombarded with a cacophony of communication most of which has a very short shelf life. There is a prime example from July, when Fed Governor Christopher Waller spoke the day before the US CPI data release. He spoke at length about the various conditions that would result in him voting for higher interest rates. The very next day the CPI report came out way softer than expected. Over the course of the two days there was around a 30 basis-point round trip in the US two-year Treasury yield. That is not to say that Mr Waller’s views were wrong or bad. The point is that future economic data is by far the most pertinent information. So, any conclusions about Mr Waller’s views are only as robust as his expectations about the next data point. History says the Fed is not good at forecasting. Thus, the theory says that open communication should supress volatility, the evidence says it often has the opposite effect. Indeed, there is a valid argument put forward by Mr Warsh that supressing volatility is not desirable anyway, and on this point he and I also strongly agree. To the extent that central bank communication has the appearance of suppressing volatility, I would strongly argue that instead it simply re-distributes it. This leads to excessive risk taking and risk-mispricing in the process. This is classic Minsky* and, in the end, leads to significant market vulnerability and dysfunction.

*US economist Hyman Minsky’s theory was that financial stability itself breeds instability.

Secondly, the issue is complexity and uncertainty and how that manifests in a reaction function. There are times when the trajectory of monetary policy is clear. When growth and inflation are low and falling it is very likely that rates need to be cut. Markets do not need their hands holding at these times. The problems come when aspects of a central bank’s mandate are in opposition and/or when the trajectory of key economic variables is highly uncertain. Today is such a time. At these times the reality is that monetary policy is more art than science, more judgement than automation. How does one weigh-up high but falling inflation, weak hiring but low unemployment, significant supply-side effects on prices versus a high and debilitating domestic cost of living? Add in a war in the middle east and a secular supply and demand shock from the rollout and buildout of large language models and associated data centres and it is an environment of incredible uncertainty. Any central banker trying to publicly explain straightforwardly and clearly how they might react in the future must choose between two options. Simplicity is very likely to give a false impression of how they may act in the future. On the other hand, a more detailed and specific explanation is likely to mean a speech, paper or article drowning in ‘if/then/else’ contingencies. This is likely to make it practically useless and unworkable, even if anyone bothers to read or listen to it in its entirety. Should you surmount both of these problems then in effect what you have done is lay down a set of rules the market will expect you to blindly follow. However, rules-based monetary policy decision making has been utterly rejected and discredited. This is by the advocates of the very same academic economic orthodoxy who wish us to believe in their simplistic view of the benefits of open central bank communication. Any rule sufficiently simple to operate effectively becomes an unwelcome straitjacket locking the institution into suboptimal and potentially dangerous decisions in the future.

These problems are not minor, they are inherent and insurmountable.

The recent public conversation has been made even worse by the confusion and conflation of this communication approach and the use of the term ‘forward guidance’.

Forward guidance was a specific communication policy borne out of the global financial crisis aftermath. As the economy slowly recovered after the foundation-shaking events of 2008 the major central banks of the world worried that a nascent economic recovery might be suffocated by financial markets’ keenness to price the first tightening of monetary policy. To prevent this situation occurring these monetary overlords decided that by ‘promising’ not to raise rates until either certain economic conditions were met or until a certain amount of time had passed, they would be able to prevent the self-defeating rise in bond yields they feared. The theory is sound enough. But in practice what happened was a load of broken promises as the central banks once again demonstrated their inability to make accurate forecasts and then demonstrated further their asymmetric fear about the effects of low versus high interest rates. They do not mind keeping rates too low for too long and pumping too much money into the system. That is because the effects normally only become clear years after those individuals have moved on. Raise rates too soon however and the bond market tells you immediately.

Those policies did not work well then, but they were an utter catastrophe after the COVID shock. The same central banks completely misjudged the economic trajectory and ended up tying themselves to policies which could not have been more inappropriate. The result was the 1970s-eque inflation wave that we are still dealing with today. If there have been monetary policy errors it was former Fed Chair Jerome Powell who made them, not Mr Warsh.

Either way, Mr Warsh correctly views these as failed experiments and possibly worth trying only during times of extreme economic and monetary outcomes. Those conditions are not present today and have not been present for years – so why should central banks be soothsaying about future policy changes at all? There is neither empirical nor theoretical justification for forward guidance policies outside of a crisis, and central banks’ ability to see past the end of their nose has been disproven again and again. Thus, the bar to just stopping such efforts should be incredibly low.

As an aside, beware any commentator who lazily conflates normal central bank communication with the term forward guidance. The latter applies to a specific set of communication policies that in combination are designed to act as a particular monetary tool.

Forecasting is hard, economies are complex and inflation is a very poorly understood phenomenon with significant measurement challenges. Setting policy today is hard enough. Trying to make clear all the future economic eventualities and the appropriate policy for each is not a herculean task, it is an exercise in futility. Attempting to do so injects, rather than reduces, volatility and reduces, rather than enhances, credibility. To the extent that central banks have ever been successful at supressing volatility, all it has achieved is higher levels of debt, leverage and vulnerability in financial markets and the state-sponsored mispricing of actual risk.

Mr Warsh is very much on the right track. His opponents are defending an approach that has delivered failures so numerous and so massive it simply defies belief.

James Athey is Co-Manager of Marlborough's Global Bond & Global Corporate Bond funds.

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