What might trip up Kevin Warsh and his agenda as Fed chair

And then there’s Kevin Warsh and his stated desire — and edict from President Donald Trump — to cut interest rates. 

Even before a hearing is scheduled on his nomination as the next Fed chair, Warsh’s ambitious agenda for “regime change” at the Fed faces challenges. The most obvious: $100-a-barrel oil prices and the incipient inflation threat they pose run counter to Warsh’s hopes to sharply reduce interest rates.

But the challenges go further. The new chair, once he takes his seat, could come up against resistance to nearly every aspect of his plan to rewrite the central bank’s operating system. Warsh has committed to slashing the Fed’s balance sheet. The overhaul could also include “breaking some heads” at the Fed, as he told Fox News in July, “because the way they’ve been doing business is not working.” That could imply staff changes or bringing in new people, as well as adjustments to the models used to forecast the economy and communications strategy the Fed uses to convey its policy outlook to markets and the public.

In all these areas, Warsh could come up against institutional resistance from Fed staff or Fed governors and presidents, and from markets that are accustomed to how the Fed does business and generally averse to change. Even getting to the chair’s seat will be a challenge for Warsh, whose hearings have been delayed by Sen. Thom Tillis‘ discontent about a criminal investigation into Fed Chair Powell. Tillis, R-N.C., says he will hold up a Senate vote on Warsh unless the Justice Department drops that probe.

Underpinning Warsh’s agenda is his deep-seated belief that the Fed has made a series of long-running policy errors. From maintaining too large a balance sheet after the emergency of the 2008 financial crisis to missing the inflation from the pandemic, Warsh believes the mistakes made by the Fed are rooted in the institution’s very fiber.

Merely installing a new Fed chair — even if it’s him — isn’t enough for Warsh.

“What the Fed needs is more robust discussion of ideas, less groupthink. I don’t like it that everyone’s following the same models,” Warsh told CNBC last year.

Warsh, in keeping with practice for federal nominees, declined to comment.

For Warsh, one thing matters most: “Fed credibility is everything.” 

Through it all, the 55-year-old former Fed governor exudes a confidence that is the antithesis of Harry Truman’s paradigmatic two-handed economist — qualities that seemed to attract the president and might be essential in his effort to reform the staid Federal Reserve. When you are Fed chair, Warsh has said, you not only need to get interest rates right, you need to “make sure you look like you know what you’re doing.”  

Warsh’s most pointed challenge could come quickly on interest rates as he’s squeezed between his and Trump’s desires on rates and on market expectations.

Markets are priced with a 35-40% chance of a rate hike by December. There is no cut priced in for at least the next 16 months and the 2-year treasury trades near 4%, a signal that markets, at least for now, think the funds rate will hold steady at best for an extended period, not go down. 

Even before the U.S. attack on Iran, futures markets had priced in only 50 basis points of cuts through 2026, suggesting markets weren’t buying that Warsh could deliver on Trump’s demands for faster, deeper rate cuts beyond the long-run neutral rate of 3%.  

That market judgment is a challenge to Warsh’s main economic argument that AI will rapidly make the economy more productive, so much so that it can deliver faster growth without generating inflationary pressures. 

Warsh’s view already finds skeptics on the Federal Open Market Committee. Chicago Fed president Austan Goolsbee told journalists in February that the Fed should not bank on growth in productivity to lead to lower price pressures. 

“You want to be extremely careful. … You can overheat the economy easily,” he said. “Let’s be a little bit careful, circumspect.” 

“Money on Wall Street is too easy, and credit on Main Street is too tight,” Warsh wrote in a November essay in the Wall Street Journal. “The Fed’s bloated balance sheet, designed to support the biggest firms in a bygone crisis era, can be reduced significantly.”

In Warsh’s game plan, a smaller balance sheet could free up funds for greater lending into the economy and banks would trade with each other for reserves, giving the Fed a truer signal of what’s happening in markets, including potentially earlier signs of systemic stress.

It all may be easier said than done. Fed Chair Ben Bernanke sparked a taper tantrum in 2013 with just the mention of the possibility of reducing Fed asset purchases. And Powell saw rates flare in 2019 when he brought reserves down too low.  

Warsh has said he is attentive to the risks of moving too fast.

“Regime change in policy shouldn’t be done overnight,” he told CNBC last year. Since resigning as a Fed governor in 2011, he has spent the past 15 years working for legendary investor Stanley Druckenmiller, a position Warsh’s supporters say has honed his perspective on the markets. 

Any effort by Warsh to reduce the balance sheet would almost certainly involve shedding some of the Fed’s $2 trillion in mortgages, which could put upward pressure on mortgage rates. It would also appear to run counter to Trump’s order to Fannie Mae and Freddie Mac to buy $200 billion in mortgages to help the housing market. 

Fed Governor Chris Waller, in a recent CNBC interview, said he supported reducing the amount of reserves the Fed holds so long as banks’ demand for reserves also fell. That could be accomplished, for instance, through some regulatory changes already in motion that would affect what assets banks are required to hold. But he opposes reducing reserves without reducing demand.

“Reducing the balance sheet, holding reserve demand constant and moving to scarce reserves, to me, that’s just idiotic,” he said. “But reducing reserve demand and then shrinking the balance sheet correspondingly — that’s something that you seriously could talk about.” 

Warsh is also promising what would be highly visible changes to the way the Fed communicates its views to the public and the markets. He has suggested he doesn’t feel compelled to contribute to the Fed’s so-called dot plot, where Fed officials anonymously record their individual preferences for the course of interest rates.

The dots ”don’t matter that much for the conduct of policy,” he said at a New York financial-sector conference in the fall.

The dots are a mainstay of Fed analysis, because they help markets infer what Fed officials are thinking. Wall Street analysts routinely put out their guesses for which dot belongs to which official. Still, they are controversial. The market focuses on the median dot and often mistakes it for a plan, even though they are derived from 19 separate forecasts and not curated into a policy forecast by the committee. 

Warsh believes the Fed overshares with the public, highlighting a general concern he has about what’s called forward guidance. The Fed leaned heavily on forward guidance in the Great Recession to keep rates low for an extended period, strongly promising easy policy in the future. In Warsh’s view, forward guidance created a problem for Powell and his colleagues in 2021 when inflation began to climb. The Fed waited before raising interest rates amid persistent inflation because it had promised to wait in its guidance.

Warsh has said adherence to outdated forward guidance cost the institution credibility.

“They were sort of tortured because they had told you what they would do. You gotta get out of that. Spend less time predicting the future and more time shaping it,” he said on a Hoover Institution podcast last year.

A Fed that pulls back on sharing its thinking could be jarring for markets and the public. Investors watch every word the Fed chair says at the press conferences that they have come to expect after each rate decision. The Fed’s top officials are sought-after guests on TV and at conferences, where their words move markets. The officials themselves may resist a chair who tries to rein them in.  

While Warsh will face obstacles to his agenda, he will hardly be powerless in implementing it. If he can make it through Senate confirmation, he will come in with several advantages. 

One is the power of the chair itself. Warsh’s skeptics like to point out that he will be only one of a dozen votes on the rate-setting FOMC, but the chair is thought of as first among equals and wields authority in other, more subtle ways. The chair sets the agenda for the committee’s meetings and directs the organization’s influential research staff. A chair who wants certain data considered will almost certainly get his or her wish.  

Warsh also has allies. The Fed is governed by its seven-member board. Warsh will likely find support in several areas from two other board members appointed by Trump, Waller and governor and regulatory chief Michelle Bowman. It remains to be seen if Trump will get more appointments to the board, including the seat of Powell — who can stay on as a governor after being replaced as chair — and other governors who could eventually decide to resign before their terms are up. Warsh will also likely play a role in directing the 12 district banks about whom to nominate when sitting presidents leave or retire. 

Warsh also brings to the Fed table a persuasive personality rooted in the confidence of his convictions — that the Fed has had it wrong and that he has it right, that there’s a substantially better way to do monetary policy. The upside would be potentially lower rates, less volatility around the Fed and its pronouncements and press conferences and, ultimately, more independence for the central bank as its smaller economic footprint puts it less in the crosshairs of the political world. The downside is a potentially rocky transition process where markets become more volatile and push rates higher due to uncertainty. To avoid that outcome, Warsh will need to convince his colleagues and markets that he has right plan to overhaul the Fed.

And, of course, it will be transcendingly important that Warsh’s analysis of what’s wrong with the Fed and his prescriptions for fixing it end up being right.