The “hall of mirrors” is a well documented problem in central bank communications. Rather than providing an independent signal about what a central bank should do, market pricing reflects a complicated feedback loop between central bank communications and economic fundamentals. The more the central bank tries to communicate how its reaction function depends on near-term developments, the more markets interpret these developments through the lens of that central bank’s reaction function. Financial markets perform best when they react to incoming data & they work less efficiently when they ask a question: How will the Federal Reserve react to that incoming information? Financial market prices are probably the most important source of information to guide central bankers. But when all the financial markets are doing is reflecting back what central bankers have said, then central bankers are blind to the most important set of information i.e true market information. Warsh believes in breaking this hall of mirrors. We believe Warsh might provide NIL forward guidance, might ensure DOTS go away while SEPs remain, post FOMC press cons to continue but far lesser content and that too on long term trends rather short term view & continuation of a more streamlined Fed speak. From a market perspective, with less forward guidance, term premiums go up and IVs remain elevated across asset classes.
