New Fed Chair Kevin Warsh Has Refused to Give Forward Guidance for 2 Straight Meetings. Here's Why That Should Worry Markets.

If you ever have to deliver bad news to someone, it's almost always a good idea to signal in advance that bad news is coming.

This can be as simple as starting with "I'm afraid I have some bad news for you..." or adopting a serious tone of voice or facial expression. These cues help the listener to emotionally prepare themselves for what's coming.

The Federal Reserve used to do something similar with monetary policy, offering forward guidance on what to expect at its next Federal Open Market Committee (FOMC) meeting, where benchmark interest rates are set. But new Fed Chair Kevin Warsh has rejected that practice, refusing to offer any indications at all about where interest rates might be heading.

Here's why that should worry markets and investors.

Federal Reserve Chair Kevin Warsh. Image source: Federal Reserve.

Brace yourself

Markets hate uncertainty, and many of the biggest one-day market moves in history have been prompted by FOMC meetings. But big one-day sell-offs are a shock to unprepared markets and can trigger cascading aftershocks.

Past Fed chairs, including Warsh's immediate predecessor, Jerome Powell, used forward guidance and carefully crafted language to signal the direction markets could expect interest rates to move at future meetings. That forward guidance helped give markets time to prepare for upcoming rate hikes. It could also help to mute the market's reaction to an unexpected decision by allowing the Fed to signal that a desired outcome might occur soon.

But Warsh believes this kind of signaling has two big drawbacks.

Why Warsh won't provide guidance

First, Warsh thinks that when the Fed offers clues about its likely next move, it interferes with the market's efficiency. He recently explained: "I think financial markets perform best when they react to incoming data. I think the financial markets work less efficiently when they ask [the] question: 'How will the Federal Reserve react?'" In other words, Warsh believes that forward guidance substitutes the Fed's interpretation of economic data for the data itself.

Second, Warsh believes that the Fed may feel compelled to honor its forward guidance to avoid upsetting markets, even if newer data conflicts with that guidance. Warsh claims such concerns don't hamstring his FOMC. "I think my colleagues ... understand the world is changing quite quickly," he said. "And they [won't] feel bound by [their current predictions] six weeks from now or six days from now in the event that their circumstances change."

What's likely to happen

While Warsh's objections are logical, they ignore a simple fact: Even if the Fed offers no guidance, the markets aren't going to stop trying to guess its next move.

For example, after Warsh's most recent press conference, where he offered no clues about how the Fed might act to curb inflation, bond markets interpreted his silence as meaning the Fed wouldn't take any action at all. That triggered a steep bond sell-off that spilled over into the stock market, sending the Dow Jones Industrial Average (DJINDICES: ^DJI) down 840 points.

That 840-point drop could be nothing compared to the impact on the S&P 500 if the markets expect a rate cut but get a rate increase, or vice versa. Investors should be prepared for increased market volatility around FOMC meetings as long as Warsh maintains this new policy.

John Bromels has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.