Warsh can bring a much-needed trade-off on rates to the Fed

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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.

The writer is chief market strategist at Jefferies

The naive market narrative on Kevin Warsh suggests he has historically been a policy hawk who suddenly changed into a dove for political reasons. That, however, is a deeply flawed analysis.

It misses the most salient points of the likely low interest rate policy framework of the Federal Reserve chair-designate. In particular, Warsh has longstanding “supply-side” leanings on what drives economic growth and he has signalled a willingness to consider explicit trade-offs between balance sheet size and interest rate levels when setting monetary policy. 

Let us first discuss Warsh’s approach to macroeconomic analysis. When a supply sider like him sees strong economic growth, without significant increases in employment or wages, the inclination is to worry more about disinflation than inflation.

While an old school Keynesian would be blabbering on about the economy “overheating” and the need for a monetary policy tightening, a neoclassical supply sider would be focusing on “productivity” and the risk that creative destruction in labour markets may actually require an easing in monetary policy.

Warsh will have some powerful supply-side ammo in the data when it comes to advancing a lower rate thesis around the table at the Federal Open Market Committee given that strong growth has coincided with rising unemployment.

But he will have to argue against current Fed staff models used to analyse the economy. Those behemoths have their roots in deeply flawed 1960s and 1970s Keynesian concepts on relationships between economic variables such as the Phillips curve and Okun’s Law (cue the output from “ferbus”, aka the FRB/US staff model, or as I like to call it “ferbuseless”). A forcible dismantling of such flawed tools would help legitimise Warsh’s agenda. 

Turning to the Fed’s balance sheet, Warsh has historically advocated for a much smaller level. More recently, however, he has neutralised this hawkishness with support for an explicit dovish trade-off via lower interest rates. As someone who has long argued that one should never speak of a neutral interest rate structure without first outlining the parameters of a neutral balance sheet level, this is highly welcome. The specifics of his trade-off have not yet been advanced, but one could imagine something like 0.75 percentage points of cuts for every $1tn reduction in balance sheet as an opening salvo. 

Bringing such a debate to the FOMC table would be a huge step forward. The central bank’s downplaying of any major role for the balance sheet when calibrating the stance of monetary policy led to a complete misjudgement of the level of stimulus that remained in the system during the 2022-23 rate rise cycle. And that in turn led to massive miscalculations on the impact of those hikes on the economy. 

There will, of course, not only be internal pushback to an explicit rate versus balance sheet trade-off policy. The big bank holding companies, through their grip on the New York Federal Reserve, have pushed hard against a low-rate/low-balance-sheet approach to monetary policy. These folks love the extra margin on their interest income that comes with higher rates, and they love the large interest payments that come with more excess reserves held at the Fed.

But the Fed chair has many powerful tools to push for change both internally and externally. Internally, Warsh can elevate the power of his comrades and dismantle the existing power of his adversaries on the FOMC committee. There are many chess pieces for him to play on the supervision, regulation, international affairs, and financial stability fronts, to name just a few. And he can use the candy in his deregulatory bag of goodies to get the big banks over to his side. Once there, those banking folks can also be quite persuasive in bringing any stubborn committee members in line.

Warsh’s ability to navigate this complex political game and bring 11 other FOMC members along for a low-rate ride will be the ultimate test of his ability to be a successful chair. I’m betting he has the skillset to get it done.

As such, Donald Trump will soon no longer have Jay “Too Late” Powell to insult after every FOMC meeting. He will instead have Kevin “Low Rate” Warsh to cheer on as he moves to corral the wily crew of committee members. In the end, I fully expect a lower rate/lower balance sheet outcome for monetary policy, which in turn will bring some much-needed relief to Main Street while keeping the party going for Wall Street.