The Fed’s fool in the shower

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via James E. Thorne:

Milton Friedman’s “fool in the shower” is the right warning for the Federal Reserve. The fool turns the tap because the water feels cold, ignores the delay in the pipes, and keeps turning until the water becomes scalding. Monetary policy works the same way. Rates affect the economy with long and variable lags. A Fed that sets policy for yesterday’s inflation risks manufacturing tomorrow’s recession.

That is the danger of a rate hike now.

Warsh’s Jackson Hole speech was weak precisely because it did not meet this institutional challenge. If he cannot stop the Fed from hiking into a supply shock while inflation is declining and expectations remain well anchored, it will reveal that he is not prepared for the difficult work of changing a reaction function hijacked by a crude Keynesian reflex: growth is presumed inflationary, every rise in prices is treated as excess demand, and rate hikes are assumed to cure every form of inflation.

The Fed needs to leave Plato’s cave, where the shadows on the wall still resemble the 1970s, and confront the economy it is actually governing in 2027, one in which the United States is a dominant energy power and temporary supply shocks need not be mistaken for a permanent demand problem.

The risk is that the Fed gives in to the Fed prediction market, a self-referential “Hall of Mirrors” in which policymakers respond to pricing shaped by expectations of what policymakers will do. If Warsh cannot persuade the FOMC to avoid hiking into a fading supply shock, with underlying inflation cooling and expectations well anchored, he becomes complicit in that feedback loop rather than breaking it.

That is why this is a small but consequential test for Warsh. He needs to change the Fed’s reaction function, much as Alan Greenspan changed the institution’s operating framework in an earlier era. That requires ripping off the bandages: making explicit that policy cannot be governed by backward-looking inflation trauma, market atmospherics, or fear of disappointing a priced-in outcome.

The transition may cause volatility. But avoiding volatility is not a monetary-policy strategy.

The inflation evidence has moved in the Fed’s direction. Core CPI has fallen to its lowest level since March 2021. Core PCE is set to be revised closer to the less error-prone CPI signal. The spring flare-up increasingly looks like a one-off energy shock, not a renewed underlying inflationary impulse. Core-PCE moving averages are declining and remain consistent with inflation returning to target over the period when today’s policy settings will actually bite.

The Fed held in June and July. To become more hawkish now, as inflation data improve, would make its reaction function look arbitrary.

Credibility does not come from permanently sounding tough. It comes from showing that policy follows the data and an intelligible economic framework. When inflation and inflation forecasts are declining, policy should become less restrictive at the margin, not more so.

The Fed should be setting policy for late 2027 and early 2028, not relitigating the inflation of 2023, or reacting to a temporary shock this spring. And stop living in Plato’s cave: living in the shadows of the 1970s energy crisis.

Otherwise, it is still
Friedman’s fool in the shower: turning the tap harder after the water has already begun to warm. The Fed should not respond to the prediction market. The proposition that it must hike simply because a prediction market expects a hike, even as the data argue for a pause, should be put to bed.

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