Countering Walsh? Fed Governor Waller: Forward guidance 'valuable,' but needs flexibility

Divergence within the Federal Reserve over communication methods regarding monetary policy is emerging.

Federal Reserve Governor Christopher Waller said on Monday at a central banking forum hosted by the Bank of Italy in Rome that forward guidance remains a valuable policy tool but needs to be used flexibly. This statement stands in stark contrast to the stance of incoming Fed Chair Kevin Warsh, who deliberately downplays forward guidance.

Monday's speech indicated that Waller acknowledged forward guidance is not applicable in all scenarios but is reluctant to abandon it entirely. The direct implication of Waller's remarks for the market is that while the Fed's policy statement has removed forward guidance, there is not a unified front within the Fed's decision-making body. In the current environment of intertwined inflation and employment risks and highly uncertain policy direction, how the Fed communicates with the market will directly influence interest rate expectations and financial conditions.

Meanwhile, current Fed officials remain divided on balancing inflation and employment risks. Waller said the labor market is showing signs of stabilization, allowing policy focus to shift toward inflation, and noted that "the risks have completely flipped," which will affect policy direction judgments.

Warsh leads the shift, Waller states his stance

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

Last month, Warsh chaired his first Federal Open Market Committee (FOMC) meeting. The post-meeting statement removed language about the direction of future interest rate adjustments. At the subsequent press conference, Warsh also refused to provide interest rate forecasts, citing his disagreement with forward guidance.

Last week, speaking at the European Central Bank's annual central banking forum in Portugal, Warsh said financial markets and the real economy operate best when left to judge conditions on their own. He criticized that Fed officials have historically had a tendency to "feed" signals to the market, which might have been reasonable during crises "but is not suitable for the current environment."

Waller, on the other hand, explicitly stated he is unwilling to abandon 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 times and will continue to play a role in the future. But forward guidance is more an art than a science, and it has sometimes hindered rather than helped policy making."

Effective timing: Lessons from the pandemic inflation cycle | Ineffective timing: Lessons from being "handcuffed"

Waller cited the fall of 2021 as an example of forward guidance significantly accelerating policy transmission under specific conditions. At that time, the FOMC signaled to the market that it would tighten policy. Even though the Fed did not officially raise rates until March 2022, the two-year Treasury yield had already risen nearly 200 basis points cumulatively from September 2021 to mid-February 2022.

According to reports, Waller noted that this increase shortened the typical 12- to 24-month policy transmission lag by about six months. "When forward guidance works, it can change economic conditions faster than simply adjusting the policy rate," he said.

However, Waller also acknowledged the clear limitations of forward guidance. From 2020 to 2021, the Fed signaled that rates would remain unchanged for a period, but inflation then rose rapidly. In hindsight, that stance constrained the FOMC's actions, leading to an unnecessary delay in rate hikes. Waller bluntly stated that the previous overly rigid forward guidance "ultimately handcuffed the FOMC in 2021."

He also pointed out that forward guidance is equally ineffective when multiple economic scenarios have similar probabilities and the policy path is difficult to determine.

Waller compared this situation to approaching an intersection when the light turns yellow—a driver either stops or accelerates through, but cannot make "stopping in the middle of the intersection" the baseline scenario. "You cannot simply take a weighted average of various scenarios and use that as the 'baseline forecast' for forward guidance," he said.

Forward Guidance vs. Reaction Function: Two Distinct Concepts

In his speech, Waller emphasized the conceptual distinction between forward guidance and the reaction function, providing an analytical framework for the current debate over policy communication.

He defined the reaction function as a framework that conveys to the market how policymakers will respond to economic shocks—"give me the data, plug it in, and I'll tell you what I'll do." In contrast, forward guidance announces to the public and markets where policy will or might go before actual data is available. "These are two very different operations," Waller said.

He stated that as long as a central bank's reaction function is clear and well understood by the market, policy officials do not need to speak much. "If your reaction function is not clearly defined and the market doesn't understand it, then you need to speak." He emphasized that clearly communicating policy objectives and how the central bank responds to data to the market is an effective way to reduce uncertainty.

Labor Market Stabilizes, Risk Landscape Shifts

On the macro assessment, Waller believes the current policy environment is undergoing a key change. He previously supported rate cuts in 2025 to boost employment, but on Monday said the U.S. labor market has shown signs of stabilization, allowing the Fed's policy focus to shift toward inflation.

"The risks have completely flipped," Waller said. "That changes the way you think about policy direction."

Notably, Fed officials held rates steady last month, but expectations for rate hikes have increased after inflation rose to its highest level since 2023.

The dot plot released after last month's FOMC meeting showed that among the 18 Fed officials who provided interest rate forecasts, nine—or half—expect at least one rate hike this year. Against this backdrop, the subtle difference in policy communication between Waller and Warsh could materially influence how the market interprets the Fed's next moves.

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