Concerns are growing that Kevin Warsh, the new chair of the Federal Reserve, despite strong professions of adherence to price stability, is acquiescing in a de facto 3% inflation rate for the US, rather than the Fed’s official target of 2% inflation. Discussion of the US failure to hit its inflation target and recent volatility-inducing Fed communications were dominant themes of the OMFIF advisory council meeting on 5 August.
The meeting debated the usual recent combined intervention to strengthen the yen by the US and Japanese monetary authorities. The OMFIF council examined the US Treasury leg of the intervention, financing it with sales of euro for yen. This avoided outright dollar sales – a move that might have otherwise pressured yields on US Treasury securities, which the Trump administration wants to hold down.
There was scepticism whether the intervention would have durable effects because it did not tackle the root causes of yen weakness: high Japanese debt, fiscal expansion and low interest rates.
Mark Sobel, OMFIF’s chief economist, vice chair and a former senior US Treasury official who at one time was in charge of the Treasury’s foreign exchange holdings, voiced doubts about the tactics of US Treasury Secretary Scott Bessent: ‘If the Treasury wishes to keep rates from going up, it should do something about fiscal policy.’
Moderated by Norman Lamont, advisory council chairman and former UK chancellor of the exchequer, the meeting assembled 33 council members from Africa, Asia, Australia, Europe, the Middle East and North and South America. Lamont focused the gathering on the path of the US economy and reaction to President Trump’s tariff policies as well as on Warsh’s initial approach to communications, which has encountered widespread criticism on financial markets.
The US economy was reported to be holding up relatively well, with growth expected at 2% or more this year, aided by booming artificial intelligence investment and buoyant consumption. But Trump was running into significant unpopularity, particularly among middle-class voters, as a result of perceptions that rises in the cost of living were not keeping pace with wages.
Glitches over credibility and communications
Warsh’s problems were epitomised by the rise in bond yields during the two Federal Open Market Committee meetings over which he has presided in June and July, characterised by glitches over credibility and communications. There was puzzlement over whether he was a ‘hawk’ (view after the first meeting) or a ‘dove’ (the second), amid suggestions that he was not hiking because of Trump’s likely hostility.
The meeting heard strong doubts about the wisdom of Warsh’s apparent desire to see open disagreement among FOMC members, seen as highly unlikely to add to stability. According to Sobel, ‘It’s early days. We’ll have to see whether he does better or not. One of the strong criticisms about his approach is that it is going to contribute to volatility. Another thing is that if he is not going to provide the forward guidance and set the tone, then markets will look for someone else [from the FOMC] to do this.’
Questions were raised about the probable effect on the bond market of a rise in the Fed’s inflation target from 2% (which has not been met in the past five years) to 3%. The meeting heard that the Fed was never likely to state formally that it was changing the target, but that a mood might take hold that the target had moved upwards.
Disruptive, but not catastrophic
There were different views on the likely effects. One participant said it would undermine credibility, trigger further rate hikes and create some disruption, but wouldn’t be a catastrophe. Another said markets and private sector actors would soon start to make decisions made on the basis of much higher price rises. Under a 2% inflation regime, prices doubled over 33 to 34 years, whereas, with 3%, prices doubled over 33-34 years.
There was a discussion on international trade, with the World Trade Organization becoming irrelevant because of the way the US is treating the trade issues, without going through negotiations and rules. One member said: ‘We’re moving towards a state where tariffs are going to be there whether we like it or not, but it is remarkable how resilient the economy is.’
The uncertainties over the Fed stance had implications for the gold market, undergoing an upwards correction in the last few days. This sends a message, according to one participant, that ‘inflation is getting a bit stronger’. He added: ‘Central bank demand for physical gold continues to increase. This year is likely to see central banks purchasing a net 1000 tonnes for the fifth year in a row. There is now a higher percentage of gold in world monetary reserves than dollars.’
Andrea Correa is Head of Research and David Marsh is Chairman at OMFIF.
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