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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.

The Perils of Powell: Inflation, Illiquid Banks, Lonnng Lags

01 Saturday Apr 2023

Posted by in Inflation, Monetary Policy

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To the great chagrin of some market watchers, the Federal Reserve Open Market Committee (FOMC) increased its target for the federal funds rate in March by 0.25 points, to range of 4.75 – 5%. This was pretty much in line with plans the FOMC made plain in the fall. The “surprise” was that this increase took place against a backdrop of liquidity shortfalls in the banking system, which also had taken many by surprise. Perhaps a further surprise was that after a few days of reflection, the market didn’t seem to mind the rate hike all that much.

Switchman Sleeping

There’s plenty of blame to go around for bank liquidity problems. Certain banks and their regulators (including the Fed) somehow failed to anticipate that carrying large, unhedged positions in low-rate, long-term bonds might at some point alarm large depositors as interest rates rose. Those banks found themselves way short of funds needed to satisfy justifiably skittish account holders. A couple of banks were closed, but the FDIC agreed to insure all of their depositors. As the lender of last resort, the Fed provided banks with “credit facilities” to ease the liquidity crunch. In a matter of days, the fresh credit expanded the Fed’s balance sheet, offsetting months of “quantitative tightening” that had taken place since last June.

Of course, the Fed is no stranger to dozing at the switch. Historically, the central bank has failed to anticipate changes wrought by its own policy actions. Today’s inflation is a prime example. That kind of difficulty is to be expected given the “long and variable lags” in the effects of monetary policy on the economy. It makes activist policy all the more hazardous, leading to the kinds of “boom and bust” cycles described in Austrian business cycle theory.

Persistent Inflation

When the Fed went forward with the 25 basis point hike in the funds rate target in March, it was greeted with dismay by those still hopeful for a “soft landing”. In the Fed’s defense, one could say the continued effort to tighten policy is an attempt to make up for past sins, namely the Fed’s monetary profligacy during the pandemic.

The Fed’s rationale for this latest rate hike was that inflation remains persistent. Here are four CPI measures from the Cleveland Fed, which show some recent tapering of price pressures. Perhaps “flattening” would be a better description, at least for the median CPI:

Those are 12-month changes, and just in case you’ve heard that month-to-month changes have tapered more sharply, that really wasn’t the case in January and February:

Jason Furman noted in a series of tweets that the prices of services are driving recent inflation, while goods prices have been flat:

A compelling argument is that the shelter component of the CPI is overstating services inflation, and it’s weighted at more than one-third of the overall index. CPI shelter costs are known as “owner’s equivalent rent” (OER), which is based on a survey question of homeowners as to the rents they think they could command, and it is subject to a fairly long lag. Actual rent inflation has slowed sharply since last summer, so the shelter component is likely to relieve pressure on CPI inflation (and the Fed) in coming months. Nevertheless, Furman points out that CPI inflation over the past 3 -4 months was up even when housing is excluded. Substituting a private “new rent” measure of housing costs for OER would bring measured inflation in services closer the Fed’s comfort zone, however.

The Fed’s preferred measure of inflation, the deflator for personal consumption expenditures (PCE), uses a much lower weight on housing costs, though it might also overstate inflation within that component. Here’s another chart from the Cleveland Fed:

Inflation in the Core PCE deflator, which excludes food and energy prices, looks as if it’s “flattened” as well. This persistence is worrisome because inflation is difficult to stop once it becomes embedded in expectations. That’s exactly what the Fed says it’s trying to prevent.

Rate Targets and Money Growth

Targeting the federal funds rate (FFR) is the Fed’s primary operational method of conducting monetary policy. The FFR is the rate at which banks borrow from one another overnight to meet short-term needs for reserves. In order to achieve price stability, the Fed would do better to focus directly on controlling the money supply. Nevertheless, it has successfully engineered a decline in the money supply beginning last April, and recently the money supply posted year-over-year negative growth.

That doesn’t mean money growth has been “optimized” in any sense, but a slowdown in money growth was way overdue after the pandemic money creation binge. You might not like the way the Fed executed the reversal or its operating policy in general, and neither do I, but it did restrain money growth. In that sense, I applaud the Fed for exercising its independence, standing up to the Treasury rather than continuing to monetize yawning federal deficits. That’s encouraging, but at some point the Fed will reverse course and ease policy. We’ll probably hope in vain that the Fed can avoid sending us once again along the path of boom and bust cycles.

In effect, the FFR target is a price control with a dynamic element: the master fiddles with the target whenever economic conditions are deemed to suggest a change. This “controlled” rate has a strong influence on other short-term interest rates. The farther out one goes on the maturity spectrum, however, the weaker is the association between changes in the funds rate and other interest rates. The Fed doesn’t truly “control” those rates of most importance to consumers, corporate borrowers, government borrowers, and investors. It definitely influences those rates, but credit risk, business opportunities, and long-term expectations are often dominant.

The FOMC’s latest rate increase suggests its members don’t expect an immediate downturn in economic activity or a definitive near-term drop in inflation. The Committee may, however, be willing to pause for a period of several meeting cycles (every six weeks) to see whether the “long and variable lags” in the transmission of tighter monetary policy might begin to kick-in. As always, the FOMC’s next step will be “data dependent”, as Chairman Powell likes to say. In the meantime, the economic response to earlier tightening moves is likely to strengthen. Lenders are responding to the earlier rate hikes and reduced lending margins by curtailing credit and attempting to rebuild their own liquidity.

Is It Supply Or Demand?

There’s an ongoing debate about whether monetary policy is appropriate for fighting this episode of inflation. It’s true that monetary policy is ill-suited to addressing supply disruptions, though it can help to stem expectations that might cause supply-side price pressures to feed upon themselves (and prevent them from becoming demand-side pressures). However, profligate fiscal and monetary policy did much to create the current inflation, which is pressure on the demand-side. On that point, David Beckworth leaves little doubt as to where he stands:

“The real world is nominal. And nominal PCE was about $1.6 trillion above trend thru February. Unless one believes in immaculate above-trend spending, this huge surge could 𝙣𝙤𝙩 have happened without support from fiscal and monetary policy.”

In reality, this inflationary episode was borne of a mix of demand and supply-side pressures, and policy either caused or accommodated all of it. Nevertheless, it’s interesting to consider efforts to decompose these forces. This NBER paper attributed about 2/3 of inflation from December 2019 – June 2022 to the demand-side. Given the ongoing tenor of fiscal policy and the typical policy lags, it’s likely that the effects of fiscal and monetary stimulus have persisted well beyond that point. Here is a page from the San Francisco Fed’s site that gives an edge to supply-side factors, as reflected in this breakdown of the Fed’s favorite inflation gauge:

Of course, all of these decompositions are based on assumptions and are, at best, model-based. Nevertheless, to the extent that we still face supply constraints, they would impose limits to the Fed’s ability to manage inflation downward without a “hard landing”.

There’s also no doubt that supply side policies would reduce the kinds of price pressures we’re now experiencing. Regulation and restrictive energy policies under the Biden Administration have eroded productive capacity. These policies could be reversed if political leaders were serious about improving the nation’s economic health.

The Dark Runway Ahead

Will we have a recession? And when? There are no definite signs of an approaching downturn in the real economy just yet. Inventories of goods did account for more than half of the fourth quarter gain in GDP, which may now be discouraging production. There are layoffs in some critical industries such as tech, but we’ll have to see whether there is new evidence of overall weakness in next Friday’s employment report. Real wages have been a little down to flat over the past year, while consumer debt is climbing and real retail sales have trended slightly downward since last spring. Many firms will experience higher debt servicing costs going forward. So it’s not clear that the onset of recession is close at hand, but the odds are good that we’ll see a downturn as the year wears on, especially with credit increasingly scarce in the wake of the liquidity pinch at banks. But no one knows for sure, including the Fed.