The differences within the Federal Reserve regarding the communication of monetary policy are coming to light.

Written by: Li Dan, Wall Street Journal

Federal Reserve Governor Waller stated on Monday, June 6, at a central bank forum organized by the Bank of Italy in Rome, that forward guidance remains a valuable policy tool but needs to be applied flexibly. This statement stands in stark contrast to the stance of the newly appointed Fed Chair Warsh, who deliberately downplays the significance of forward guidance.

This Monday's speech showed that Waller acknowledges that forward guidance is not applicable in all situations but is unwilling to completely abandon it. The direct implication of Waller's remarks for the market is that although the Fed's decision statement omitted forward guidance, the Fed's decision-making body is not united. In the current environment where inflation and employment risks are intertwined and policy direction is highly uncertain, how the Fed communicates with the market will directly influence interest rate expectations and financial conditions.

Meanwhile, current Federal Reserve officials still have differences in weighing inflation and employment risks. Waller stated that the labor market is showing signs of stabilization, allowing the policy focus to shift towards inflation, and pointed out that "the risks have completely reversed," which will affect the judgment of policy direction.

Warsh Leads the Shift, Waller Establishes His Position

Since taking office, Warsh has clearly expressed his aversion to forward guidance.

Last month, the first FOMC meeting chaired by Warsh after his appointment was held, during which the decision statement released afterward removed the language regarding forward guidance on future interest rate adjustments. At the subsequent press conference, Warsh also refused to provide interest rate forecasts, reasoning that he does not agree with forward guidance.

Last week, Warsh also stated at the European Central Bank's annual central bank forum in Portugal that financial markets and the real economy operate best when they make judgments independently, noting that past Fed officials had a tendency to "feed" signals to the market, which may have been reasonable in times of crisis, "but is not appropriate in the current environment."

Waller, on the other hand, explicitly stated that he is unwilling to give up the tool of interest rate guidance. He said:

"I have always believed that forward guidance is a valuable tool that has significantly enhanced policy effectiveness at certain times and will continue to play a role in the future. But forward guidance is more an art than a science; it sometimes hinders policy formulation rather than helps it."

Effective Timing: Experience from the Pandemic Inflation Cycle; Ineffective Timing: Lessons of Being "Bound Hand and Foot"

Waller used the autumn of 2021 as an example to illustrate that forward guidance can significantly accelerate policy transmission under specific conditions. At that time, the FOMC sent signals to the market that it would tighten policy; even though the Fed did not officially raise interest rates until March 2022, from September 2021 to mid-February 2022, the yield on two-year U.S. Treasury bonds rose by nearly 200 basis points.

According to reports, Waller pointed out that this increase was equivalent to shortening the typical 12 to 24-month lag in policy transmission by about six months. "Forward guidance can change economic conditions more quickly than simply adjusting the policy rate when it works," he said.

However, Waller also acknowledged the clear limitations of forward guidance. From 2020 to 2021, the Fed sent signals that interest rates would remain unchanged for a period, but inflation then rose rapidly. In retrospect, this statement constrained the FOMC’s actions, leading to an unnecessarily delayed rate hike. Waller bluntly stated that the previously rigid forward guidance "ultimately bound the FOMC's hands in 2021."

He further noted that when various economic scenarios have similar probabilities and policy paths are difficult to determine, forward guidance is also hard to be effective.

Waller compared this situation to approaching an intersection in a vehicle while encountering a yellow light—the driver must either stop and wait or speed through, but cannot simply "stop in the middle of the intersection" as a baseline scenario. "You cannot simply take a weighted average of various scenarios to serve as a 'baseline forecast' for forward guidance," he said.

Forward Guidance and Reaction Functions: Two Distinct Concepts

Waller emphasized the conceptual difference between forward guidance and reaction functions in his speech, which also provides an analytical framework for the current policy communication controversy.

He defined the reaction function as the framework for communicating to the market how policymakers will respond to economic shocks—"Give me the data, plug it in, and I will tell you what I will do"; while forward guidance is about announcing to the public and the market what the policy will or might be moving towards before actual data is obtained. "These are two completely different operations," Waller said.

He noted that as long as a central bank's reaction function is clear and fully understood by the market, policymakers actually do not need to speak too much. "If your reaction function is not well-defined and the market does not understand it, then you need to talk." He emphasized that clearly conveying policy goals and the response to data to the market is an effective means to reduce uncertainty.

Labor Market Stabilization, Changing Risk Landscape

In terms of macro judgment, Waller believes that the current policy environment is undergoing significant changes. He previously supported a rate cut in 2025 to boost employment, but on Monday expressed that signs of stabilization have emerged in the U.S. labor market, allowing the Fed's policy focus to shift towards inflation.

"Risks have completely reversed," Waller said, "and this will change the way you think about policy direction."

It is noteworthy that although Fed officials maintained interest rates last month, rate hike expectations have warmed after inflation rose to its highest level since 2023.

The dot plot released after last month’s FOMC meeting showed that among the 18 Federal Reserve officials providing interest rate forecasts, nine, or half, expect that the Fed will raise rates at least once this year. In this context, the subtle differences in policy communication between Waller and Warsh may have a substantial impact on how the market interprets the Fed's next moves.