Former Fed governor Kevin Warsh says government officials should be wary of market calm

As Hamish Douglass puts it, there’s a “brutal honesty” about former Fed governor Kevin Warsh.

Still, his intimate involvement in the Fed’s crisis management through the global financial crisis and the start of quantitative easing would have been handy during the pandemic.

Now a consultant to Magellan Financial Group, Warsh is well placed to weigh up the risks faced by the global economy and financial markets and his thoughts ring true.

For anyone in financial markets, business, politics or investing, the entire 7900-odd words of his podcast with Magellan’s chairman and CIO should be essential listening.

Refreshingly, Mr Warsh is happy to admit that he could be wrong on his assessment of the risks and his wish is that central bankers these days would also be a bit more humble.

In his view, they need to come to these jobs with a strong sense of risk management.

“Rarely the right question that a central bank like the Fed should be asking is ‘if everything goes right, what will we do?’ The question they should have asked in the period between the last crisis and this crisis, a period of 10 years, was ‘what happens if something goes wrong?’”

“What should we do about that? What happens if something goes wrong?

“They should simply be asking the question today.”

His hope is that privately, at least, central bankers – particularly those at the Fed – admit that “we don’t know” and are intensely focused on the risk that things don’t evolve as they expect.

Of course, a lot’s gone right since the darkest days of Covid-19 and when he hears government policymakers offering reassurance after reassurance and suggesting all is benign, he hopes they’re right and is just part of the “marketing” and that when they leave the microphone they go back to their jobs and they say, “and what happens if we’re wrong?”

His judgment is that markets are able to hear complicated messages.

“And so I hear a lot of confidence from the Fed these days,” Warsh says.

“I hope they’re right about inflation being transitory, but we’ve never run this experiment.”

“We’ve talked a little bit about the extraordinary use of fiscal and monetary policy. Well I’d state that simply is we have pro-cyclical, fiscal and monetary policy to an economy that’s already back to its peak of 14 months ago. That strikes me as strange.”

This dose of realism comes from a man who helped deal with the carnage in 2008 when Fannie Mae and Freddie Mac effectively failed, with about $US5 trillion of outstanding liabilities held by many of the world’s largest investors, including foreign governments.

“We confronted a situation that weekend, where those firms, absent government support, wouldn’t be able to pay any of that money back,” Mr Warsh recalls.

To him that was when it was “all but obvious that the system was in really great harm’s way”.

But “in some sense, it was scarier then because markets didn’t appreciate the fear”.

“When markets are scared, when markets are fearful, in some sense, they’re doing their jobs, and they’re policing,” he says.

“When markets are calm, invariably calm, when the VIX (index of volatility in S&P 500 futures) is low, that’s when government officials, frankly, should be quite scared.

“And that was, I thought, quite an alarming moment for policymakers a dozen years ago.”

Warsh has huge respect for former Fed chairman Ben Bernanke for coming up with the broad notion and supporting it as aggressively as he did. At the time he had no idea that QE1 would work.

“I think it was our fourth or fifth idea product that we’d rolled out in the crisis,” Warsh recalls.

“The others didn’t seem to work so well, but it came a point where we would roll out products before the Asian markets opened, I guess I should say before the Australian markets opened, so that we’d have a chance of getting through a Monday morning in New York Stock Exchange time when the US Treasury markets opened.”

But when the Federal Reserve decided to roll out QE2 in the second half of 2010, the US and global economy had picked up “rather dramatically”.

His grave concern at the time was that “if we did QE2, we’d end up doing QE346, and it would become a rather permanent feature of a monetary policy toolkit”.

“My concerns weren’t shared by most, probably then or now, because if in fact we’ve gone to a world where QE is standard operating procedure, and obviously what you do, then governments, economies, markets can grow dependent on it,” Warsh warns.

“In which case, when you get hit with a real shock, as we did in March of last year, March of 2020, you end up having to do still more aggressive things because you’ve convinced the markets that QE is quite normal operations.”

His figures the normal job of an economist or certainly a central banker is to look over the horizon.

“What’s going to be the state of the economy six or nine or 12 months from now?

Because until very recently, what we believed was economic policy, that is fiscal policy and monetary policy, acted (with) … long and variable lags.

“Any decision that’s made today on stimulus will find its way into the economy sometime later.”

He’s struck that there’s a “brand new regime in economic thought, at least here in the US”.

“And chairman Powell and many of his colleagues have said that they’re no longer going to be that focused on the horizon. They’re going to look out their window and see whether inflation and the economy have hit their objectives. And if so, then and only then will they act.”

“So, that’s a new paradigm in economic policy,” Warsh says.

“If I follow their counsel and I look out my window right now, this is the strongest economic growth, certainly since the early 1980s in the US, and I think by the time we’re done, we’ll say it was the strongest period of growth in the post-war era. So that’s an amazing statement.

“So as I see quite a vibrant, strong economy in the US, I’m then struck by one other fact.

“We have the loosest financial conditions that we’ve ever been able to measure in the United States.”

He says the mix of fiscal policy, monetary policy, and financial markets means financial conditions “looser than they were in the darkest day of the global financial crisis of ’08 or ’09 or any day in between.”

“And I just didn’t think I would be around for a period of such strong growth, such a high level of output, and the decision by policymakers to have such loose policy.

“So that’s a striking feature.

“That’s the moment that we’re in now.”

Which begs the question of whether it’s sustainable, the beginning of a new cycle, or is an economy that’s had a “shock and a release, but that we’re in the late stage of?”

Mr Warsh says financial markets are now “ebullient” and there are “bubbles across many parts”.

“We have to ask ourselves the question which is, ‘if it’s a bubble, when would it bust?’

“How could it bust and what would happen and I think we’re at greater risk of that in this environment where we’re applying such aggressive medicine to a patient that is largely healed in the US, it takes the risks of a bubble bursting still higher.”


This article was originally posted on The Australian here.

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