By Raul Elizalde
Kevin Warsh assumes the role of Fed Chair after a political battle that culminated in the narrowest-ever Senate vote to confirm a central bank head. He is undoubtedly a controversial pick who advocates lowering rates amid rising inflation. Suspicion runs high that his mission is to placate President Trump's insistence that the Fed cut rates. With the president having pushed for the nomination, concern is growing that the era of Fed independence may be coming to an end.
Each of the seven members of the Fed's board is nominated by the U.S. president and serves a 14-year term, while the top three roles, including the chair, last four years. Outgoing chief Jerome Powell is ending his last 4-year term but retains time on his full 14-year term and, unlike prior chairs, has suggested he will remain until it expires.
While Warsh may favor cutting rates, any such move requires a vote by the Federal Open Market Committee, which comprises the seven governors plus five of the twelve regional Fed presidents on a rotating basis. Few expect him to win a consensus to cut rates while inflation is accelerating, so his personal inclinations, though relevant as chair, are not decisive.
Warsh is not a newcomer to the world of public policy and central banking. He served at the National Economic Council under President George W. Bush before becoming a Fed governor from 2006 to 2011, working closely with then-Chair Ben Bernanke during the 2008 Great Financial Crisis. Notably, as the worst of the crisis passed – when prices were falling, CPI was negative, and policymakers feared deflation – he argued for raising rates.
Virtually any economist would recommend lower rates to counter deflation and higher rates to counter inflation. In that sense, Warsh has been consistent in advocating for the opposite medicine than others would normally prescribe. He has also consistently opposed the Fed’s accumulation of assets in its balance sheet.
The Fed has two tools for monetary policy: interest rates and the money supply. Following the Great Financial Crisis, it cut rates to zero, and unable to go further, began purchasing fixed-income instruments by the trillions, thus injecting money into the economy by essentially printing it. This became known as Quantitative Easing (QE).
Its impact, however, was quite muted. Banks, the first recipients of that new money, deposited much of it back at the Fed as interest-bearing excess reserves. The massive injection didn’t even prevent inflation to fall back into negative territory at the beginning of 2015.
This, incidentally, went against Milton Friedman’s catchy but outdated 1963 dictum that "inflation is always and everywhere a monetary phenomenon." That concept may have held back when the money supply turnover was relatively high and stable, but that turnover measure (the “velocity of money”) has fallen steadily since those days, rendering the maxim rather obsolete. The Fed can print all the trillions of dollars it wants, but if those dollars do not circulate, they have no inflationary effect.
The opposite of QE is Quantitative Tightening (QT): selling or allowing assets on the Fed's balance sheet to mature, thereby removing money from the economy. This is where Warsh's thinking may find its opening.
QT is a restrictive policy, while cutting rates is an easing policy. By pursuing QT while conceding a rate cut, Warsh could placate the president while still arriving at a net-restrictive stance, as long as the tightening effect outweighs the easing one.
source: Federal Reserve Bank of St. Louis
Research on the equivalence between changes in balance sheet size and interest rates remains inconclusive, but estimates suggest a $600 billion to $1.2 trillion change in the balance sheet may be roughly equivalent to a quarter-point move in rates. If the Fed were to reduce its holdings from $6.7 trillion to, say, $5 trillion, a 25bp cut could leave policy marginally more restrictive on net.
That said, complications abound. Such a move could push the Fed Funds rate below the current inflation rate, potentially sending real rates into negative territory – bad for savers, but convenient for financing the ballooning federal deficit. A shrinking money supply could also weigh on non-financial assets like real estate, crypto, and gold, with effects that are difficult to predict. On the upside, reducing fixed-income holdings limits the Fed's exposure to mark-to-market losses when longer-term rates rise, thus freeing it from unwelcome congressional scrutiny. It also restores capacity for future QE, if needed.
In sum, Warsh enters an very complex environment. His vote is one of twelve, and however firm his unorthodox convictions, his ability to move the committee on the direction he favors is constrained. One wonders whether he is starting to regret pursuing this new role.
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