He stated what’s been clear to everyone but the Fed: amid too-high inflation, Financial Conditions are not “restrictive.”

By Wolf Richter for WOLF STREET.

Fed Chair Warsh stuck to his guns in his Jackson Hole speech and further crushed any remaining shards of forward guidance. It creates a “hall-of-mirrors problem,” where the markets rely on the Fed’s guidance, and the Fed relies on market prices for guidance, and “we are all more likely to be blinded to new developments, more likely to be caught unprepared for a turn of events, and more likely to commit errors in policymaking,” he said, a reference to the debacle in 2021 when the Fed, with rates at 0% and QE running at full tilt, refused to react to soaring inflation. And he added:

“Perversely, market participants are unlikely to bear the biggest costs of the hall-of-mirrors problem. The most serious harm is likely to befall those without financial assets. If the Fed gets inflation wrong and judges the economy wrong, who gets the worst of it? Not the financial high-fliers. Hard-working Americans are the ones left to deal with inflation that is too high or jobs that suddenly appear less secure.”

So forward guidance is dead. Markets have to figure it out on their own. And they did today, and they figured that inflation would get taken seriously, and Treasury yields jumped, with the 6-month yield spiking by 9 basis points, the 1-year and 2-year yields by over 11 basis points.

So forward guidance is still dead. But he did talk about the economy, about the boom in corporate investments in fixed assets and software, with over half of it linked to the AI infrastructure buildout. He talked about credit spreads on corporate bonds and leveraged loans being “near the low ends of their historical ranges,” while issuance volumes of these instruments “have been quite strong this year”; about how profits of the companies in the S&P 500 have ballooned, that profit margins were “quite elevated,” and that expectations for growth in cap-ex and corporate profits were “running quite high.”

“Banks tell us that standards for commercial and industrial loans are on the easier end of their historical range. That helps explain the growth we’ve seen this year in those loans. Credit and loan markets are showing few signs of policy restraint,” he said.

While housing and agriculture were struggling, he noted that “on balance, I would be hard pressed to describe broad financial conditions as restrictive.”

That’s a key issue. By raising interest rates, and thereby tightening monetary policy, the Fed tries to make financial conditions more “restrictive,” meaning that it costs more to borrow, and that it becomes more difficult to borrow, and that the spreads widen so that riskier debt, such as junk-rated debt, gets relatively more difficult and expensive to sell, compared to highly-rated corporate debt or Treasury securities.

And that financial conditions have been loosey-goosey, instead of restrictive, has been obvious for a long time in just about all measures that track financial conditions, including the Chicago Fed’s National Financial Conditions Index (NFCI), which has been bumping along the loosey-goosey bottom of its historic range, deeply in the negative, when positive values would denote restrictive financial conditions.

According to these measures, financial conditions have been ultra-loose, indicating that the Fed’s policy rates are far too low to create even balanced or neutral financial conditions.

Everyone could see that, except apparently the majority of the policy makers at the FOMC, which spent last fall patting each other on the back and cutting rates.

And Warsh went on: Consumer spending, adjusted for inflation, “has been healthy despite the shocks,” and the labor market is “quite stable,” with the relatively low turnover being “partly a result of the significant rematching between employers and employees that happened at scale in the post-pandemic environment.” And with the labor force “barely growing, monthly job gains are naturally going to run low.”

But then there’s inflation, where “the numbers are more concerning.” He cited the all-items PCE price index (+3.7% year-over-year, +4.1% six-month), and said that CPI was “also elevated,” and that “inflation remained too high.”

They all “tell a similar story: Inflation is running above our 2% target. So the Fed’s predominant focus right now should be on prices.” And the recent better-than-expected PCE and CPI readings “do not tell me that underlying trends have meaningfully improved.”

And he added: “We must be confident that underlying inflation is moving to our objective, clearly and at sufficient speed. Otherwise, we have work to do. That’s our job, our mandate, and our charge to keep.”

And he pointed out correctly and refreshingly: “There is one signal nobody can miss: The responsibility for 65 months of sustained, elevated inflation sits squarely with the central bank.” Are you listening, Powell?

So let’s see what the majority on the FOMC will decide. All policy decisions are made by a vote of 12 participants, and the majority decides. It’s Warsh’s job to build a majority for his point of view, but that might be tough. If he can’t, he’s just talking.

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