The Case for Federal Reserve Discretion

T he Book of Ecclesiastes famously taught that to everything there is a season. This would also seem to be the case as to whether the Federal Reserve should be bound by rigid rules or whether it should be allowed to exercise a great degree of monetary policy discretion. Rigid rules seem appropriate in times of economic and political stability. On the other hand, monetary policy discretion would seem appropriate in today’s world of great economic and geopolitical uncertainty.

Fortunately, Kevin Warsh, the Fed’s new chair, is fully tuned in to the heightened economic uncertainty that today’s Fed must navigate in setting interest rates. In a striking departure from his predecessor Jerome Powell, Warsh has made clear that he will not offer the markets forward guidance as to rate policy, and he will not offer a personal forecast as to where the economy might be headed. By refraining from doing so, he believes this will increase the Fed’s discretion to respond to economic and financial market developments as they occur. At this week’s Federal Open Market Committee meeting, markets expect Warsh to hike interest rates in response to continued inflationary pressures and to the renewed spike in international oil prices.

Warsh should stick to his view that today’s world of heightened uncertainty calls for a humbler Fed that avoids forward guidance or economic forecasting. And there is little doubt that heightened uncertainty is what we are looking at now. Unsustainable public finances are causing U.S. and world sovereign bond markets to become unstuck; a Japanese bond and currency market crisis is threatening to cause a reversal of the Japanese yen carry trade; an artificial intelligence revolution is boosting demand for the capital to finance it, creating bubble-like conditions in the stock market, and holding out the promise of a once-in-a-generation productivity boom; a super El Niño is threatening to cause global food shortages of unknown dimension next year; and the wars in Iran and Ukraine are unsettling world energy and food markets.

Anyone doubting that the U.S. government bond market is coming unstuck has not been paying attention to recent bond-market developments. The 30-year U.S. Treasury bond yield has spiked to a 20-year high of 5.3 percent while the 10-year Treasury bond yield has now passed the psychologically important 5 percent level. Driving these yields higher is an annual budget deficit of more than $2 trillion that could soon widen further because of the need for increased defense spending and higher debt service costs.

It must be concerning that foreigners, who own around $8.5 trillion, or 30 percent, of all Treasury bonds outstanding, now seem to be losing their appetite for U.S. assets as the Trump administration weaponizes both fiscal and tariff policy. Indeed, France and Germany are repatriating their gold holdings from New York, and the Norwegian sovereign wealth fund has announced plans to reduce its Treasury bond holdings by $80 billion, or nearly 40 percent. How sure can the Fed be that it will not soon be facing a full-blown bond-market crisis?

Over the past two decades, a key factor supporting U.S. and world financial markets has been the so-called Japanese yen carry trade. Investors have borrowed massive amounts of Japanese yen at low interest rates to invest in higher-yielding U.S. and world financial market assets. The Fed now must contend with the real risk that international markets could soon be roiled by the unwinding of this carry trade as Japan might need to repatriate capital to defend its currency and as higher-yielding Japanese government bonds become more competitive with foreign bonds. Underlining this risk is the fact that, despite recent foreign exchange market intervention, the Japanese yen remains near a 40-year low, while Japanese government bond yields are now at multi-decade highs amid concerns about Japanese public debt sustainability.

Yet another factor that could soon roil domestic and global financial markets is a French sovereign debt crisis. The risk is heightened because France will go to the polls in April to elect a new president, at a time when its public finances are on a clearly unsustainable path, and its politics are dysfunctional. Anticipating that France will continue to lack the political will after the election to address its public debt problem in a way likely to reassure creditors, French government bond yields are now trading at their highest levels since the 2010 Eurozone sovereign debt crisis.

The Fed is also having to set interest rates at a time when the country is experiencing a once-in-a-generation revolution in artificial intelligence. That revolution offers the hope of a productivity surge that will put downward pressure on prices. However, hopes about what AI might deliver are also fueling an investment boom that is adding meaningfully to aggregate demand that could exacerbate the inflation problem. The Fed’s problem is that the timing of the hoped-for AI boom is far from clear. Its pressure on capital is clear enough, and the same might be true of its effect on aggregate demand, but when will the boost to productivity start coming through?

As though all this economic uncertainty were not enough of a challenge for monetary policymaking, the Fed now has to make policy amid unusually heightened geopolitical uncertainty, from the Iran and Ukraine wars to China’s growing assertiveness. Complicating the story further, how these conflicts play out could determine whether we face another energy price shock or another period of unusually low energy prices.

All of this would seem to support Kevin Warsh’s call for a Fed that doesn’t box itself in.