Hi, this is Yves. James Galbraith has crafted an insightful article that effectively critiques the limited impact of Federal Reserve actions within today’s economic framework, illuminating the necessary steps for Kevin Warsh. His piece articulately dismantles several misconceptions that have shaped Fed policy and the views of numerous economists and investors. Galbraith highlights how Warsh signals a departure from the outdated thinking of previous officials. A crucial takeaway is that higher interest rates may have little effect on curbing inflation, and that artificial intelligence represents a force of creative destruction, differing from conventional notions of productivity improvements.
I encourage you to take some time to engage with this article; it contains many valuable insights presented in a refreshingly simple manner.
By James K. Galbraith, Lloyd M. Bentsen Jr. Chair in Government and Business Relations, University of Texas at Austin. Originally published at the Institute for New Economic Thinking website
Kevin Warsh, Chair of the Federal Reserve, has faced a range of criticisms, labeled variously as “Trump’s sock puppet” and “utterly conventional.” Still, his inaugural speech at Jackson Hole was notable for its thoughtful and humorous tone, devoid of Trump-esque rhetoric. However, Warsh appears to be ensnared within the confines of mainstream monetary theory. Acknowledging this, he boldly called for the Fed to “receive the full range of ideas” on monetary policy, aiming to foster more reliable economic models. Let’s hope this commitment is genuine.
Forward Guidance
On a particularly contentious point, Warsh argued for reduced “forward guidance,” asserting that it hampers the Fed’s flexibility and cultivates a feedback loop influencing market behaviors based on Fed announcements rather than economic realities. By limiting these statements, he suggests, there may be less fuel for speculative trading. While this is a step worth considering, speculators will likely continue to wager on future policy decisions, potentially increasing their stakes due to heightened uncertainty. The upside may be that analysts, who currently read Fed statements like oracles, will be compelled to refocus their efforts elsewhere.
Setting Interest Rates
Warsh dismissed many misunderstandings surrounding interest rates with refreshing clarity: “We determine the path of short-term interest rates.” A plaque with those words could be sent to Ken Rogoff, Paul Krugman, and other Washington think tanks and lobby groups that obsess over the federal budget deficit. Warsh’s straightforward assertion effectively debunks the outdated “loanable funds” theory and its companion, “crowding out,” emphasizing that the Fed has perennial control over short-term interest rates.
Moreover, it’s important to recognize that the Fed also usually influences long-term rates through arbitrage: long bonds serve as a substitute for a series of short notes. Long bond rates represent a combination of current short-term rates and anticipated future rates, while other factors remain largely peripheral. As the Fed maintains low short-term rates over extended periods, long-term rates tend to follow suit. Recent increases in long-term rates—such as in the current global “bond rout”—indicate market expectations of rising short-term rates. This dynamic operates independently of CBO debt projections, which have been more politically motivated than economically relevant. As noted by Robin Brooks of the Brookings Institution in his Substack, there is currently no discernible US fiscal risk premium.
Many observers, including Brooks, Claudia Sahm, and others, contend that the Federal Reserve might (and perhaps should) raise interest rates to “stabilize expectations” and demonstrate independence from Donald Trump. However, the expectations argument lacks substance and is likely misguided; “one-and-done” stands out as rare in the history of Fed funds. Once a rate-raising trend is initiated, many traders will anticipate successive increases—“squeezing the pips until they squeak.” Furthermore, raising rates merely to challenge the President does not express independence; it reflects insecurity, signaling that monetary policy is swayed by political optics—an inadvisable message for a new Chair to convey.
The Dual Mandate and the Two Percent Target
Warsh acknowledged the dual mandate of full employment and “reasonable” price stability as defined by the 1978 Humphrey-Hawkins Full Employment and Balanced Growth Act. However, he neglected to mention the duty to report to Congress regarding the Fed’s actions. Perhaps Congress should remind him of the law:
SEC. 108. (a) Section 2A of the Federal Reserve Act is amended by striking out the second and third sentences and inserting in lieu thereof the following: “In furtherance of the purposes of the Full Employment and Balanced Growth Act of 1978, the Board of Governors of the Federal Reserve System shall transmit to the Congress, not later than February 20 and July 20 of each year, independent written reports setting forth (1) a review and analysis of recent developments affecting economic trends in the Nation; (2) the objectives and plans of the Board of Governors and the Federal Open Market Committee concerning the growth or reduction of monetary and credit aggregates for the calendar year during which the report is transmitted, considering past and expected developments in employment, production, investment, real income, productivity, international trade, payments, and prices; and (3) the relation of the above objectives and plans to the short-term goals outlined in the most recent Economic Report of the President as per section 3(a)(2)(A) of the Employment Act of 1946 and any short-term objectives approved by Congress.”
This law stipulates a reporting obligation that the Fed must fulfill regarding monetary policy conduct, aligned with short-term goals established in the Act. Those objectives specify four percent unemployment and three percent inflation for the entire government, not solely the Federal Reserve. The Fed lacks a specific inflation mandate. Moreover, as Professor Stephanie Kelton points out, the inflation target is secondary to the employment objective.
Provided, That policies and programs aimed at reducing the inflation rate should be designed so as not to hinder the achievement of the goals and deadlines specified in clause (1) of this subsection regarding reducing unemployment.
In essence, Congress prohibited the use of policies that might slow the economy or increase unemployment in pursuit of “reasonably” stable prices, defined ad interim as three percent inflation measured by the consumer price index.
Consequently, Warsh significantly misrepresented the widely-discussed two percent inflation target when he referred to it as “our mandate.” In truth, it is not dictated by statute and remains an internal goal that originated in New Zealand and gained traction during the “inflation targeting” trend of the late 1990s. Additionally, as Professor Kelton reminds me, a first-hand account by Larry Summers indicates that in 2012, Chairman Bernanke sought—and received—President Obama’s “permission” to adopt the two-percent target. Such a blatant act of non-independence and disregard for the law is astounding.
Nevertheless, Warsh’s commitment to the two-percent target formed the core of his speech. He expressed unwavering dedication to this goal, calling it “our charge to keep.” However, it also represents the weakest link in his perspective, which warrants a closer examination, particularly regarding what he articulated—and what he omitted—about the “new economy.”
The Two-Percent Target in the Age of AI
Warsh’s remarks began by addressing innovation, investment, and the implications of artificial intelligence. He noted how previously dominant notions from Summers (secular stagnation), Robert J. Gordon (technological slowdown), and Ben Bernanke (the “global savings glut”) are no longer applicable. However, he didn’t pause to consider that they may have never been valid. Specifically, Bernanke’s assertion that Chinese savers (under capital controls) influenced US interest rates seems absurd in hindsight. Did those pressures dissipate? No. It might have been more polite to acknowledge that these ideas and many others stem from a series of age-old ideological misconceptions.
So, how does Warsh conceptualize AI? His language reveals a key insight. He describes AI as a potential “new factor of production” with the capacity for “substantially higher growth” and a “sustained increase in productivity.” This conventional phrasing grounds Warsh’s thinking in a traditional economic model that assumes a linear relationship between “capital” and “labor,” where technological advancements invariably enhance productivity. In this framed perspective, productivity is defined as the ratio of output to labor input—concepts that often go unchallenged among economists of Warsh’s generation (and even mine).
However, this model is fundamentally flawed when applied to contemporary capitalism and the information economy. Technology represents creative destruction, which inherently dismantles existing structures. New technologies can render previously valuable goods and services obsolete, driving them out of economic relevance. This phenomenon, particularly pronounced in the information age, is starkly evident when recalling the expensive communication tools of the analog era.
Historically, technological advances, aided by government intervention, were associated with growth and the creation of new markets, as seen with the transition from horse-drawn transport to automobiles. However, the current technological wave seems to erase market activities—decreasing the cost of communication and analysis to such an extent that they often become free. Discussing AI in terms of productivity growth reflects an outdated mindset, rooted in the neoclassical growth theories of the past. Notably, Warsh made no mention of the potential disruptive impact of superior and cheaper Chinese AI on American innovations—a consideration that cannot be understood through conventional production functions but could unfold in real-world scenarios.
So, how does AI challenge conventional inflation understanding? Paul Krugman references plummeting communication prices as indicative of rising wealth, encapsulating a mindset tied to historical spending patterns. If true, price levels should reflect a markdown, leading to heightened real incomes. Nonetheless, most individuals do not feel this way; they are increasingly burdened by essential costs such as food, electricity, health insurance, and rent. Consequently, measured “inflation” will reflect the evolving prices of the items that remain in the index, especially among less economically stable households, increasingly focusing on essentials that are witnessing price hikes.
It’s possible that with “moderate” wage settlements—characterizing a scenario where workers wield minimal bargaining power—there may be a declining average inflation rate over time, as household spending shifts to sectors marked by rising prices. However, opposing forces are at play: while current profits are robust (Warsh noted this positively, despite profit increases often deriving from rising prices), AI investments are energy-intensive and increasing energy costs, compounded by US policies that seem geared towards disrupting oil markets—issues not addressed by Warsh. These pressures will inevitably permeate pricing dynamics, making the two-percent average increasingly elusive, even if wage levels remain stable.
Moreover, the varying consumption patterns across different household types render the average inflation rate largely abstract. For each household, the critical issue is the price of the items they consume. When it comes to housing, rising costs afflict renters, but for many American families, housing represents an asset they own. Actual rents present a significant financial strain, yet the growing “imputed rent” that homeowners “pay” to themselves translates to increased wealth, akin to a rise in the stock market. Are reduced prices for existing homes inherently desirable? If so, why not aim for lower prices for corporate stocks as well?
In a landscape characterized by structural changes, diverse spending patterns, and rapid technological advancements, the two-percent “consumption expenditure” target emerges as somewhat arbitrary. It is also evidently challenging to achieve, and it remains a dilemma that AI will not resolve. In short, this target is as outdated or inconsequential as Bernanke’s “savings glut” or Summers’ “secular stagnation.” Since it lacks a legal foundation, the Fed can opt to discard this mistaken goal.
Higher Interest Rates Have Lost Their Traction Against “Inflation”
What is unequivocal is that hiking the “path of short-term interest rates” will not reduce inflation. During Paul Volcker’s tenure, the economy relied on limited credit for consumer spending and business investment. When the Fed raised rates to twenty percent in 1981, manufacturing employment, investment, wages, and purchasing power plummeted, with the dollar surging and imports becoming cheaper. However, manufacturing has since lost its primacy, and trade unions no longer dictate wage negotiations. Consequently, there is no direct link between increased rates and diminished growth, higher unemployment, or slower price increases.
Currently, federal debt stands at roughly four times larger relative to GDP than it was back then. Raising rates consequently injects money into economic activity—predominantly within the service sector, which is less sensitive to interest rates—and pushes asset prices, further contributing to PCE inflation. Additionally, if housing construction decreases, rental prices will rise. Declines in consumer spending on cars and durable goods disproportionately affect imports, lessening the impact on domestic production. Jerome Powell raised the Federal Funds rate by over 500 basis points, yet the economy did not contract, and the policy exerted little or no influence on inflation, which has been predominantly driven by supply-chain issues and oil prices, before subsequently fading over time.
Hence, the one instrument under the Fed’s control—the “path of short-term interest rates”—remains mired in uncertainty, from which Kevin Warsh struggles to escape. Neither tough rhetoric nor higher rates will genuinely influence the pace of inflation. Alternative approaches involving diplomatic relations with Iran, détente with China and Russia, and strategic price controls would be necessary—all of which lie beyond the Federal Reserve’s jurisdiction.
Decisions Based on “Data”: A Commitment to Short-termism
Warsh has garnered considerable praise from the media and commentators for his unwavering position on the two-percent target. This is typically interpreted as a signal that interest rates will rise eventually. He asserts that the specific timing will hinge on “the data.” A closer examination of this point raises a troubling question: What data?
If no decisions have yet been made, the only data influencing them will pertain to monthly or quarterly economic news. By positioning himself as responsive to “the data,” Warsh has tethered the Fed to an extreme form of short-termism, reliant on current news. However, early economic data is often subject to revisions and can provide a misleading narrative. Even when accurate, short-term data may not provide a long-term perspective; fluctuations that appear one month can recede the next.
This approach contrasts starkly with sound policy-making practices. It differs significantly from the strategies employed by either Paul Volcker or Alan Greenspan, despite my reservations regarding both. Volcker aimed to restructure the economy by dismantling synchronized wage negotiations known as the “Treaty of Detroit” and thereby curtail union power (which he did by decimating the industries employing these workers). Greenspan notedly exercised restraint, avoiding premature actions during the Internet boom, even when unemployment fell, and the NAIRU theory dominated the 1990s. Both resisted the immediate pressures of economic news, instead prioritizing larger objectives, structural analyses, and political convictions.
Warsh has similarly committed to his stated goal, staked his reputation on it, yet lacks the means for fulfillment. New “evidence” will not provide the necessary solution.
Conclusion: What Should He Do?
So, what actions should Chairman Warsh take now? He cannot cut interest rates, as President Trump has effectively prohibited that option by expressing a desire for it to occur. Conversely, raising rates based solely on “the news” proves futile and counterproductive.
Ultimately, the appropriate path is clear: do nothing. As Warsh indicated, the current landscape is novel and fraught with uncertainty. A strategic pause is warranted. He must display resilience in the face of pressures from all directions. In the meantime, he should actively seek out the fresh ideas, keen critiques, and original thinkers who could help steer the Federal Reserve out of its ideological impasse. It could once again become – as it was in the 1930s and 1940s – an arena where unconventional thought can thrive.
One can only hope.
