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A Warsh Policy Scenario At the Federal Reserve

16 Monday Feb 2026

Posted by in Federal Reserve, Monetary Policy

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Kevin Warsh has been nominated by President Trump as the next Chairman of the Federal Reserve Board. He’d step into the role in May if confirmed by the Senate. Warsh has served on the Board before, from 2006-2011. During that tenure, he was basically opposed to quantitative easing and expansion of the Fed’s balance sheet, though he voted for QE1 in 2010 in deference to then-Chairman Ben Bernanke, while offering a dissenting opinion.

A Chairman Warsh would have allies some at the Fed, but whatever direction he might prefer for policy, it’s not clear that he can or would swing policy decisions. The Board of Governors has seven members, not all of whom would ally with Warsh, while the Federal Open Market Committee (FOMC), the main policy-setting arm of the Fed, has 12 voting members. And the influential Fed staff might offer resistance to Warsh’s views. Nevertheless, it’s worth asking how his views would take shape as Fed policy if they held sway.

Warsh has said the Fed’s balance sheet should shrink and that the Fed should reduce its target rate for the federal funds rate. Of course, the latter aligns with Trump’s exhortations. Sharply lower rates are desired by the Administration as a tonic for consumers and businesses. Furthermore, reducing the federal government’s interest costs on the public debt would bring a meaningful reduction in the deficit, or at least give Trump room for new spending initiatives.

Some might wonder whether shrinking the Fed’s balance sheet — selling securities to the public — is consistent with an effort to reduce rates. After all, selling securities on the open market by the Fed is usually associated with higher rates and tighter monetary policy. When the Fed’s balance sheet shrinks, we call it quantitative tightening. And yet Warsh calls for lower rates.

Whether you agree with either of the Warsh objectives, their combination can at least be reconciled. A sharp reduction or prohibition on interest paid by the Fed to banks on their reserves (IOR) would go hand-in-hand with other steps by the Fed to reduce short-term interest rates. Eliminating or reducing the rate earned on reserves would create an incentive for banks to purchase the assets that Warsh would have the Fed divest from its balance sheet. That would also have to be accompanied by the reestablishment of minimum reserve requirements for banks.

Of course, bank incentives matter only to the extent that regulations don’t stand in the way. Currently, bank regulations penalize large banks for investing in Treasuries, despite minimal risk. So-called Supplementary Leverage Ratio (SLR) rules require large banks to hold from 3% up to 6% capital against all assets on their balance sheets. In addition, long-term Treasury securities held by banks can trigger flags for rate-risk exposure, and mark-to-market rules might lead to adverse fluctuations in bank regulatory capital.

Warsh has been a critic of expansive bank regulation by the Fed. It’s likely that he would support Vice Chairwoman Michelle Bowman’s push for deregulation, and would be in the same corner on that point as Treasury Secretary Scott Bessent. New rules would take time to promulgate and implement, but surely Warsh recognizes that shrinking the Fed’s $6.5 trillion portfolio would have to be a protracted affair in any case. In fact, an effort to reduce the Fed’s balance sheet in 2019 was halted after liquidity became a concern in the repurchase market.

For perspective on the $6.5 trillion portfolio, private U.S. commercial banks currently hold about $25 trillion in assets, but total bank reserves at the Fed are almost $3 trillion, including reserves held by foreign banks. This limits the extent to which the Fed’s balance sheet can be drawn down via uptake by commercial banks.

A potential switch by the Fed from ensuring “ample reserves” to a system of “scarce reserves” sets off alarm bells among many Fed watchers and within the Fed itself. Resistance to the change is based in part on the need for adequate “backstops” to ensure the safety of the banking system under scarce reserves. In this connection, there always were backstops under scarce reserves, including a well-functioning market for overnight loans of reserves between banks (federal funds) as well as the Fed’s own Discount Window, which it operates as lender of last resort. Most importantly, a steady and reliable policy course would minimize economic and financial disruptions and therefore the need for extraordinary measures. Beyond that, in times of volatility or financial stress it’s necessary to take a longer perspective on asset valuation, rather than relying too heavily on short-term market fluctuations, before leaning into “too big to fail” solutions. In fact, Warsh has said the following:

“The Fed, as first-responder, must strongly resist the temptation to be the ultimate rescuer.

And this:

“The Federal Reserve is not a repair shop for broken fiscal, trade or regulatory policies.“

Would this approach, steadily shrinking the Fed’s balance sheet while scaling back IOR, succeed in reducing key interest rates? It could reduce some consumer and business loan rates that are indexed to the fed funds rate or to the prime rate. Long-term rates are another story, as they are governed by fundamentals like expectations of economic growth and inflation. But beyond the evolution of the balance sheet, the rate of IOR, the fed funds rate, and bank reserves, there are measures of greater interest to the full thrust of monetary policy: the rate of growth of the money supply relative to nominal aggregates like GDP.

Warsh has been described as a “inflation hawk”, and has described himself as a “student of Milton Friedman”. That should assuage any fears that a “Warsh Fed” would be inclined to monetary activism for economic or political reasons.

What Trump might want and what Warsh, as Fed Chairman, is willing or able to do are two different things. Trump has loudly called for an immediate cut in the fed funds rate of 100 basis points or more, which is not going to happen. Such a large cut in the target rate (and IOR) would alarm markets, particularly without firmly establishing the Fed’s intentions for both its inflation (or other) target and the transition to a new reserve/balance sheet regime. In fact, any future policy actions should be predicated on inflation and other economic data.

But who knows? Warsh has said that the proliferation of AI will engender massive gains in productivity, which would be a deflationary force. We can only hope! Perhaps that would provide all the rationale Warsh needs for expansionary monetary policy… a smaller balance sheet with rate cuts and non-inflationary money growth.

There have been comments from Warsh and Treasury Secretary Scott Bessent that the Fed can reach some kind of new “accord” with the Treasury with respect to the Fed’s balance sheet and debt issuance. It’s not clear what this might entail, but it could be a simple matter of clearly outlining plans to level-set market expectations. The Fed has reduced the average maturity of its Treasury debt holdings. Perhaps Bessent can persuade Warsh and the Fed to lengthen maturities as the Fed’s portfolio runs off. But there are other avenues for a possible accord, such as guides for action on the provision of liquidity by the Fed, regulatory matters, and bounds around interventions that might influence debt issuance.

Here are a few bullet points to summarize the Warsh policy scenario I outlined above:

  • Shrink the Fed’s balance sheet
  • End the ample reserves regime
  • Reduce or eliminate interest on bank reserves
  • Deregulate bank balance sheets
  • Guide rates lower and provide monetary accommodation for productivity growth

That’s a lot for a new Fed Chair to bring together. Events might conspire to prevent some of those steps, but that’s stab at a Warsh roadmap for monetary policy.

A Monetary Cease-Fire As Inflation Retreats, For Now

20 Tuesday Jun 2023

Posted by in Inflation, Monetary Policy

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The inflation news was good last week, with both the consumer and producer price indices (CPI and PPI) for May coming in below expectations. The increase in the core CPI, which excludes food and energy prices, was the same as in April. As this series of tweets attempts to demonstrate, teasing out potential distortions from the shelter component of the CPI shows a fairly broad softening. That might be heartening to the Federal Reserve, though at 4.0%, the increase in the CPI from a year ago remains too high, as does the core rate at 5.3%. Later in the month we’ll see how much the Fed’s preferred inflation gauge, the PCE deflator, exceeds the 2% target.

Inflation has certainly tapered since last June, when the CPI had its largest monthly increase of this cycle. After that, the index leveled off to a plateau lasting through December. But the big run-up in the CPI a year ago had the effect of depressing the year-over-year increase just reported, and it will tend to depress next month’s inflation report as well. After this June’s CPI (to be reported in July), the flat base from a year earlier might have a tendency to produce rising year-over-year inflation numbers over the rest of this year. Also, the composition of inflation has shifted away from goods prices and into services, where markets aren’t as interest-rate sensitive. Therefore, the price pressure in services might have more persistence.

So it’s way too early to say that the Fed has successfully brought inflation under control, and they know it. But last week, for the first time in 10 meetings, the Fed’s chief policy-making arm (the Federal Open Market Committee, or FOMC) did not increase its target for the federal funds rate, leaving it at 5% for now. This “pause” in the Fed’s rate hikes might have more to do with internal politics than anything else, as new Vice Chairman Philip Jefferson spoke publicly about the “pause” several days before the meeting. That statement might not have been welcome to other members of the FOMC. Nevertheless, at least the pause buys some time for the “long and variable lags” of earlier monetary tightening to play out.

There are strong indications that the FOMC expects additional rate hikes to be necessary in order to squeeze inflation down to the 2% target. The “median member” of the Committee expects the target FF rate to increase by an additional 50 basis points by the end of 2023. At a minimum, it seems they felt compelled to signal that later rate hikes might be necessary after having their hand forced by Jefferson. That “expectation” might have been part of a “political bargain” struck at the meeting.

In addition, the Fed’s stated intent is to continue drawing down its massive securities portfolio, an act otherwise known as “quantitative tightening” (QT). That process was effectively interrupted by lending to banks in the wake of this spring’s bank failures. And now, a danger cited by some analysts is that a wave of Treasury borrowing following the increase in the debt ceiling, along with QT, could at some point lead to a shortage of bank reserves. That could force the Fed to “pause” QT, essentially allowing more of the new Treasury debt to be monetized. This isn’t an imminent concern, but perhaps next year it could present a test of the Fed’s inflation-fighting resolve.

It’s certainly too early to declare that the Fed has engineered a “soft landing”, avoiding recession while successfully reigning-in inflation. The still-inverted yield curve is the classic signal that credit markets “expect” a recession. Here is the New York Federal Reserve Bank’s recession probability indicator, which is at its highest level in over 40 years:

There are other signs of weakness: the index of leading economic indicators has moved down for the last 13 months, real retail sales are down from 13 months ago, and real average weekly earnings have been trending down since January, 2021. A real threat is the weakness in commercial real estate, which could renew pressure on regional banks. Credit is increasingly tight, and that is bound to take a toll on the real economy before long.

The labor market presents its own set of puzzles. The ratio of job vacancies to job seekers has declined, but it is still rather high. Multiple job holders have increased, which might be a sign of stress. Some have speculated that employers are “hoarding” labor, hedging against the advent of an ultimate rebound in the economy, when finding new workers might be a challenge.

Despite some high-profile layoffs in tech and financial services, job gains have held up well thus far. Of course, the labor market typically lags turns in the real economy. We’ve seen declining labor productivity, consistent with changes in real earnings. This is probably a sign that while job growth remains strong, we are witnessing a shift in the composition of jobs from highly-skilled and highly-paid workers to lower-paid workers.

A further qualification is that many of the most highly-qualified job applicants are already employed, and are not part of the pool of idle workers. It’s also true that jobless claims, while not at alarming levels, have been trending higher.

It’s important to remember that the Fed’s policy stance over the past year is intended to reduce liquidity and ultimately excess demand for goods and services. In typical boom-and-bust fashion, the tightening was a reversal from the easy-money policy pursued by the Fed from 2020 – early 2022, even in the face of rising inflation. The money supply has been declining for just over a year now, but the declines have been far short of the massive expansion that took place during the pandemic. There is still quite a lot of liquidity in the system.

That liquidity helps explain the stock market’s recovery in the face of ongoing doubts about the economy. While the market is still well short of the highs reached in early 2022, recent gains have been impressive.

Some would argue that the forward view driving stock prices reflects an expectation of a mild recession and an inevitable rebound in the economy, no doubt accompanied by eventual cuts in the Fed’s interest rate target. But even stipulating that’s the case, the timing of a stock rally on those terms seems a little premature. Or maybe not! It wouldn’t be the first time incoming data revealed a recession had been underway that no one knew was happening in real time. Are we actually coming out of shallow woods?

To summarize, inflation is down but not out. The Fed might continue its pause on rate hikes through one more meeting in late July, but there will be additional rate increases if inflation remains persistent or edges up from present levels, or if the economy shows unexpected signs of strength. I’d like to be wrong about the prospects of a recession, but a downturn is likely over the next 12 months. I’ve been saying that a recession is ahead for the past eight months or so, which reminds me that even a broken clock is right twice a day. In any case, the stock market seems to expect something mild. However misplaced, hopes for a soft landing seem very much alive.

The Fed’s Balance Sheet: What’s the Big Deal?

08 Sunday May 2022

Posted by in Government Failure, Inflation, Monetary Policy

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The Federal Reserve just announced tighter monetary policy in an attempt to reduce inflationary pressures. First, it raised its target range for the federal funds rate (on overnight loans between banks) by 0.5%. The new range is 0.75% – 1%. Second, on June 1, the Fed will begin taking steps to reduce the size of its $9 trillion portfolio of securities. These holdings were acquired during periods of so-called quantitative easing (QE) beginning in 2008, including dramatic expansions in 2020-21. A shorthand reference for this portfolio is simply the Fed’s “balance sheet”. It includes government debt the Fed has purchased as well as privately-issued mortgage-backed securities (MBS).

What Is This Balance Sheet You Speak Of?

Talk of the Fed’s balance sheet seems to mystify lots of people. During the 2008 financial crisis, the Fed began to inject liquidity into the economy by purchasing large amounts of assets to be held on its balance sheet. This was QE. It’s scope was unprecedented and a departure from the Fed’s pre-crisis reliance on interest rate targeting. QE had the effect of increasing bank reserves, which raised the possibility of excessive money supply growth. That’s when the Fed began to pay interest to banks on reserves, so they might be content to simply hold some of the reserves over and above what they are required to hold, rather than using all of that excess to support new loans and deposits (and thus money growth). However, that interest won’t stop banks from lending excess reserves if better opportunities present themselves.

The Fed has talked about reducing, “normalizing”, or “tapering” its balance sheet for some time, but it only recently stopped adding to it. With inflation raging and monetary policy widely viewed as too “dovish”, analysts expected the Fed to stop reinvesting proceeds from maturing securities, which amounts to about $95 billion per month. That would shrink or “taper” the balance sheet at a rate of about $1.1 trillion per year. Last week the Fed decided to cap the “runoff” at $47.5 billion per month for the first three months, deferring the $95 billion pace until September. Monetary policy “hawks” were disappointed by this announcement.

Monetizing Government

So, one might ask, what’s the big deal? Why must the Fed taper its securities holdings? Well, first, the rate of inflation is far above the Fed’s target range, and it’s far above the “average Joe’s” comfort range. Inflation imposes significant costs on the economy and acts as a regressive form of taxation, harming the poor disproportionately. To the extent that the Fed’s huge balance sheet (and the corresponding bank reserves) are supporting incremental money growth and fueling inflation, the balance sheet must be reduced.

In that connection, the Fed’s investment in government debt represents monetized federal debt. That means the Fed is essentially printing money to meet the Treasury’s financing needs. Together with profligate spending by the federal government, nothing could do more to convince investors that government debt will never be repaid via future budget surpluses. This dereliction of the government’s “full faith and credit”, and the open-armed acceptance of the inflation tax as a financing mechanism (à la Modern Monetary Theory), is the key driver of fiscal inflation. Reducing the balance sheet would represent de-monetization, which might help to restore faith in the Fed’s ability to push back against fiscal recklessness.

Buyer of First Resort

Perhaps just as critically, the Fed’s heavy investment in government debt and MBS represents an ongoing distortion to the pricing of financial assets and the allocation of capital. Some call this interference in the “price discovery process”. That’s because the Fed has represented a market-altering presence, a willing and inelastic buyer of government debt and MBS. Given that presence, it’s difficult for buyers and sellers to discern the true values of alternative uses of capital, or to care.

QE was, among other things, a welcome institutional development for the U.S. Treasury and for those who fancy that fresh money printing is an ever-valid form of government payment for scarce resources. The Fed’s involvement also means that other potential buyers of Treasury debt need not worry about interest rate risk, making public debt relatively more attractive than private debt. This is a dimension of the “crowding out” phenomenon, whereby the allocation of capital and flows of real resources between public and private uses are distorted.

The Fed’s presence as a buyer of MBS depresses mortgage rates and makes mortgage lending less risky for lenders and investors. As a result, it encourages an over-investment in housing and escalating home prices. This too distorts the allocation of capital and real resources, at the margin, toward housing and away from uses with greater underlying value.

Conclusion

The magnitude of the Fed’s balance sheet is an ongoing testament to an increasingly dominant role of central authorities in the economy. In this case, the Fed has served as a conduit for the inflation tax. In addition, it has unwittingly facilitated crowding out of private capital investment. The Fed’s purchases of MBS have distorted the incentives (and demand) for residential investment. These are subtle effects that the average citizen might not notice, just as one might not notice the early symptoms of a debilitating disease. The long-term consequences of the Fed’s QE activities, including the inflation tax and distorted allocations of capital, are all too typical of failures of government intervention and attempts at central planning. But don’t expect anyone at the Fed to admit it.