When Kevin Warsh scrapped the Fed’s forward guidance on Wednesday, he said almost nothing—and yet his actions spoke louder than any press release. At the same time, Washington and Tehran signed a memorandum on a ceasefire in the Persian Gulf that sounded like peace but was none. One week, two announcements, one contrast: The banker who remained silent revealed more than the statesmen who spoke.
There were two announcements this week, and the more important one was the silence.
For nearly two decades, the Federal Reserve governed less through the interest rate it set than through the words it used to describe the interest rate it might set next. The tool was language. “Forward guidance,” a term that no one outside the building would recognize as English, meant that the central bank informed the market in advance—and in reassuring stages—of the general direction in which monetary policy would move, so that prices for everything could already adjust today to a decision that had not yet been made. A described future is a tradable future. In its own way, it was the purest example of “Newspeak,” a term this column returns to time and again: a vocabulary designed to sound like information without actually committing to anything.
On Wednesday, at his first meeting as chairman, Kevin Warsh stopped talking. The committee kept the benchmark interest rate at 3.50 to 3.75 percent, where it had been since December, and keeping it there was the least of it. Warsh announced that the Fed would no longer provide any “forward guidance” at all, explaining that it was “not well suited to the current monetary policy environment” and, in case anyone might confuse this organizational measure with the actual headline, he established five working groups to rethink the institution’s approach. He reaffirmed the 2 percent inflation target, even as inflation stood at 4.2 percent—a three-year high—and let the forecasts say what policymakers are no longer allowed to state explicitly. The median view among policymakers is now that the policy rate will be higher at the end of the year than at the beginning.
Read this carefully, because it’s the opposite of what the market had been assuming all spring. The door that Warsh is keeping open isn’t the door to a rate cut. It’s the door to a rate hike. And here’s the part that the polite reports have glossed over: A man who keeps interest rates steady at 3.5 percent while inflation stands at 4.2 percent—and whose committee is now drifting toward tightening rather than easing—is a man who has tacitly accepted that inflation will remain above target for a while. He talks about 2 percent, but his actions tolerate a rate closer to 4 percent. He won’t admit this discrepancy, because no central banker ever does. Nor does he have to. The projection points speak for him. After years of central bank presidents promising to bring inflation back to the target level “in a sustainable manner,” it’s almost refreshing to see one of them stop pretending he’s in a hurry.
Two percent and the TV studio where that figure comes from
This raises a question that almost no one in the financial world is rude enough to ask out loud. Why two percent? Not three, not one, not zero. This figure is recited by every central bank in the world with the solemnity of a law of physics, enshrined in mandates, defended in hearings, and cited as justification for the cost of money across the entire planet. If you ask where it comes from, the room falls silent, because the honest answer is embarrassing. It comes from a television interview. In 1988, New Zealand’s Finance Minister Roger Douglas was asked about inflation during a live broadcast and spontaneously said that it should fall to around zero or zero to one percent. He had not discussed this with his staff.
They later rephrased this off-the-cuff remark as a target of zero to two percent; the rest of the world followed New Zealand’s lead because New Zealand had taken the first step, and a figure that a politician had mentioned one afternoon on live television became established as what, in modern economics, comes closest to a sacred constant.
There’s no theorem behind it. There is remarkably little evidence that two is better than one or three. It’s simply the number everyone agreed to repeat over and over until the repetition itself became an authority. This is Newspeak in its purest form—a word recited with the utmost seriousness by people who, for the most part, have never questioned it and would struggle to defend it if pressed to do so. Whatever else one may think of Warsh: he may be the first chairman in a generation to act as if he knows that this number is a convention rather than a mandate. This is either the beginning of honesty or the end of Anker, and it will take more than one meeting to figure out which is true.
Why Silence Speaks Louder Than a Sentence
It’s worth pausing for a moment to consider the mechanisms at play. A market that has been promised cheaper money factors this promise into every price it sets. The market assumes that cheaper money is on the way; valuations expand to accommodate this, and the more speculative cash flows further in the future—those that only make sense if borrowing remains virtually free—receive the biggest boost. Take away that promise, and you don’t just halt the rise—you remove the very foundation on which it stood. Strength is perceived as a threat in such a market, because it is strength that undoes the interest rate cuts. This is the scenario I described two weeks ago and which is now unfolding again: the return of gravity to a market that had grown accustomed to weightlessness—only this time, it wasn’t a single session marked by nervous reactions triggered by strong employment figures. It was the man in the chair who announced that he would no longer hold the market’s hand.
And that is exactly what happened. By the close of trading that Wednesday, the S&P 500 had fallen 1.2 percent and the Nasdaq 1.3 percent, while the Dow lost about five hundred points, and yields on U.S. Treasury bonds spiked as the market braced itself for tightening rather than easing. The heaviest losses were suffered by the stocks that had soared the highest thanks to the promise of cheap money: the Microsofts, Metas, Alphabets, and Amazons—the long-term technology bets whose valuations depend most heavily on borrowing costs remaining virtually free. None of this came as a surprise. A market told that cheap money will no longer be handed to it falls back on the fundamentals that are supposed to justify its existence, and the heaviest stocks fall first. The bots read a statement from which the words they had been waiting for had been stricken, found nothing to hold onto, and did the only thing left for them to do: sell.
The Machines That Make the Law
Consider who was listening. The modern market is not, in any meaningful sense, a room full of people. It is a population of programs that read the Fed’s statement the moment it is released, scan it for the few words they have learned are important (“patient,” “accommodative,” “data-dependent”), and reacting to the syntax even before a human has finished reading the first sentence. It is machines, not people, that drive the market today. The price movement seen in the seconds following a central bank statement is determined by code that reacts to grammar, not by judgment that reacts to meaning. For years, this machinery had a stable source of adjectives to feed on. Warsh has taken that text away from it.
A system designed to operate based on an adjective is ill-equipped when that adjective is removed, and a market that has outsourced its initial response to software optimized for the previous regime will, for a time, be at the mercy of tools calibrated for a world that no longer exists. The bots are still calling the shots. They’ve simply been given a blank sheet of paper to work with, and a blank sheet of paper is the one thing they never learned to read.
The other announcement that everyone just couldn’t stop talking about
The second announcement of the week was of a completely different nature. On the same day that Warsh said almost nothing, the presidents of the United States and Iran signed a memorandum intended to end a war that had begun in late February and to reopen the Strait of Hormuz, through which about one-fifth of the world’s oil must flow. Here, the language was rich and heartfelt: an agreement, an end to the fighting, peace within sixty days. The price of oil reacted accordingly to the headline. West Texas Intermediate crude fell 4.8 percent to $80.75, Brent to $83.17—its lowest level since early March—and stock prices rose, albeit only moderately, with the caution of a market that had read the fine print.
The fine print reads: This is a memorandum, not a peace agreement. It is a 60-day declaration of intent to cease hostilities, in which the nuclear issue—the very issue that actually triggered the war—has been explicitly postponed until a later date. And despite its decline, crude oil is still trading at about forty percent above its level at the start of the year. This is “Paraître” (reality versus appearance) in its natural habitat: a declaration of intent disguised as a fait accompli, a press release taking the place of an agreement. The contrast between the two announcements is the lesson of the week. The banker, who said almost nothing, revealed more to you than the statesmen who spoke at length, for a strait does not read communiqués. As I argued earlier, when this series turned to the topic of energy, the real economy is the hard constraint, and it doesn’t become any less restrictive just because a ceremony was held in a capital city. The price of oil is determined by the barrels that are transported, not by the warmth of the language used to describe the agreement to transport them.
The price that fell was paper
And here it’s worth recalling what actually fell on Wednesday. The number on the screen, which dropped by 4.8 percent, is not the price of a barrel of oil. It is the price of the promise to deliver one: a futures contract—paper traded in volumes many times greater than the physically available amount of oil. Paper can be revalued within a millisecond by a single headline. A barrel cannot. The reopening of the Strait of Hormuz based on a signed memorandum will not get the tankers stranded on both sides back afloat, nor will it lower war risk insurance, which has jumped from a quarter of a percent of the ship’s value to between three and eight percent —that’s three to eight million dollars to send a single large tanker through—nor will it magically bring back the captains and insurers who want to wait for a long period of calm before they consider the waters safe again. The backlog could clear up in two weeks. According to estimates by the shipping industry, a return to normal traffic flow is a matter of months.
Behind this figure lies a more serious reality that is not mentioned in any press release. To maintain operations during the nearly four-month disruption, the developed world has depleted its emergency reserves at a rate never seen before. Government reserves in OECD countries have fallen to their lowest level since 1990 and are projected to last for about fifty days by the end of the year—the smallest buffer since 2003— while the International Energy Agency has approved the largest coordinated release of reserves in its history. These barrels do not refill themselves. A world that has depleted its reserves to the very bottom rebuilds them by competing for the very same barrels that everyone else suddenly wants—which is just a polite way of saying that the price is rising. The futures price has therefore fallen in response to this news and could drop even further out of relief, but the physical market is quietly telling a very different story. My expectation is unpopular and, I suspect, almost inevitable.
That sense of relief is an illusion, and sometime between now and the end of fall, reality will catch up with her. In the end, the barrel wins, because you can’t burn a futures contract to heat a house.
Think of others, too
While Warsh enjoys the luxury of an economy strong enough to be left alone, his counterparts abroad find themselves in stranger situations, and it is worth naming them, because the comparison does no one any favors. America is grappling with an inflation rate of 4.2 percent, which it imported in equal parts from the Gulf region this spring and printed itself years ago: the belated bill, as this column has previously put it, for money that was created in an emergency and never taken out of circulation again. Yet it is carrying this inflation into a labor market that is still warm enough to make an interest rate cut seem reckless—which is precisely why Warsh can afford to do nothing and call it a strategy. Hardly any other central banker has this leeway.
The European Central Bank certainly doesn’t have it. This month, in an economy that grew by 0.1 percent in the first quarter, it raised interest rates by a quarter of a point—which, rounded off, amounts to zero growth—while Germany, the supposed engine of growth, achieved 0.3 percent. It is tightening monetary policy in the face of 3 percent inflation—which it did not cause itself but was imported across a strait over which it has no influence—in order to defend a single currency that spans twenty very different economies. This is the textbook example of stagflation, the scourge of the 1970s that everyone assumed had been cured. Prices are rising for reasons beyond the reach of monetary policy; the economy is stagnating for reasons that monetary policy will only exacerbate. As I’ve already said, there isn’t much to see here.
The Swiss National Bank is in a class of its own, and I say that with sincere admiration. It is effectively one of the world’s largest and most successful investment funds, holding a vast portfolio of foreign stocks—including a great many American technology companies—financed not by deposits or taxes, but by Swiss francs that it prints itself to prevent its currency from appreciating too sharply. No private asset manager in the world enjoys such a setup: an investor who creates the very money he uses to invest, and whose purchases help prop up the very assets he owns. This has worked exceptionally well for years. One simply observes—without wishing the Swiss any harm—that this is an unusual definition of a central bank, and that precisely those regulations that function exceptionally well for years are not subjected to a stress test by anyone until the year they no longer function.
Thank you, Germany
The most revealing example is the Bank of England, because the United Kingdom is being penalized in a way that makes little sense from a purely numerical standpoint. The yield on 10-year British government bonds is about 4.35 percent. The yield on comparable French bonds is about 3.88 percent. The market is therefore demanding nearly half a percentage point more to lend money to the United Kingdom than to France. Let’s now consider the two borrowers. France has a national debt of nearly 116 percent of gross domestic product, compared to 103 percent in the UK; it has failed for months to pass a proper budget; and in almost any other currency, it would be described as “insolvency in slow motion.” The two budget deficits are only a hair’s breadth apart. According to most key indicators of fiscal health, France is the weaker borrower. And yet France borrows money on more favorable terms. Why?
The answer is: the euro, which ultimately means that the answer is Germany. France does not borrow in its own name. It borrows money within a monetary union backed by Germany’s credibility and supported by a central bank that has shown more than once that it would rather buy up the bonds of its weaker members than let the project fail. A French bond is therefore valued as if a more disciplined country were standing quietly in the background—because that is exactly the case. The United Kingdom does not enjoy such protection. It borrows in its own currency, in its own name, is judged on its own merits, and the market is far less forgiving toward a country that cannot hide behind a larger one. There is a lesson to be learned from this—one that the British may not like.
Currency sovereignty is a wonderful freedom—until the moment the bond market decides to use it against you; and a place within another country’s currency, as humiliating as that may be, comes with a German guarantee that the markets factor in, even if they don’t say so openly.
What to Observe and How
The honest approach for the coming months is the one that Warsh, perhaps without intending to, has exemplified. Say less and observe the things that don’t speak. Observe whether the sixty days will weather the “nuclear issue” and whether the price of crude oil will stabilize or is merely taking a breather on its way up. Watch to see whether U.S. inflation eases or whether the task forces are the prelude to a rise that no one is allowed to announce in advance. Watch to see whether France’s borrowing costs remain pegged to Germany’s, because the day that link crumbles is the day the real arithmetic of the euro returns. And watch, more broadly speaking, to see if there are any positive surprises at all in Europe, because so far there haven’t been any.
Cash flows don’t issue press releases. A strait doesn’t care what was signed in which capital city. Inflation is indifferent to a target that a New Zealand politician made up on television. Machines will continue to make the rules, but they make them out of words, and this week the supply of reliable words at the source shrank drastically, while the supply of unreliable words skyrocketed. When the narrative falls silent, all that remains is mathematics, which is ultimately the only thing on the planet of finance that has ever told the truth.
Eric Lefebvre
See also: Planet Finance: The Engine Room
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