Incoming Federal Reserve Chair Kevin Warsh is a former Fed insider who talks like an outsider and has promised to revamp the institution and make a clean break from his predecessors.
The Senate on Wednesday voted to confirm Warsh by a vote of 54 to 45. As soon as he is sworn in, Warsh will get the chance to prove whether he can marshal skeptics on Wall Street, in Washington and inside the Fed building itself to support his goals.
Warsh, who was the youngest Fed governor in history when he worked at the central bank from 2006 to 2011, has been clear that he wants to go in a different direction than previous Fed chairs, calling for “regime change” at the central bank.
That approach isn’t typical of an incoming Fed chair.
“This is definitely a sea change from previous transitions,” Derek Tang, co-founder of LH Meyer/Monetary Policy Analytics, told MarketWatch.
Many Fed watchers are betting that Warsh will bring changes slowly because the Fed typically moves at a glacial pace. But they may be missing something, said a former colleague of Warsh’s on the Fed.
Randall Kroszner, who served as a Fed governor alongside Warsh in the early 2000s, thinks Warsh will press for action.
“Kevin won’t have the patience. He will want to move more quickly,” Kroszner said.
Still, Warsh is “one man with one vote,” and there is a committee that has to be brought on board whatever the Fed decides, said Avery Shenfeld, chief economist at CIBC Capital Markets.
Here are five challenges Warsh will face right away as he takes over as chair.
Warsh’s and the Fed’s independence will face an almost immediate test
Economists think Warsh is in for a rough start.
“He’ll be tested from day one,” Shenfeld said. “Trump wants rate cuts immediately, and Warsh isn’t likely to vote for one in the short run.”
The markets will be watching to see whether Warsh can chart a policy course that differs from the president’s wishes ahead of crucial midterm elections in November.
Kroszner, Warsh’s former colleague, said that Warsh is used to criticism and won’t be shaken.
“There was a lot of pressure being put on the Fed during the global financial crisis — things they should be doing, shouldn’t be doing. Direct criticism and from behind closed doors,” he said.
The Fed’s interest rate committee has been showing much more independence over the past nine months with fewer unanimous decisions.
Only a few months ago, it was assumed the Fed might go along with one or two rate cuts this year to allow Warsh a honeymoon period.
But the path to rate cuts has been blocked by recent high inflation readings stemming from the Iran war.
The debate at the Fed is whether Warsh can prevent the central bank from moving toward rate hikes rather than any cuts, according to a note to clients from Wall Street veteran Ed Yardeni.
Warsh’s main argument in favor of rate cuts is meeting growing skepticism
Warsh has made clear in speeches and interviews that he believes we are at the dawn of a “golden age” economy where artificial intelligence is boosting productivity and growth and lowering business costs. He’s said that combination justifies rate cuts despite inflation being above the Fed’s 2% target.
Warsh’s views on the golden-age economy mirror the views of the White House economic team, which often appeared on television to push the Powell Fed to learn a lesson from former Fed Chair Alan Greenspan. In the late 1990s, Greenspan resisted calls from many on the Fed to raise rates as the economy gained momentum, arguing that the economy was experiencing faster productivity growth from the growing use of the internet.
Warsh hasn’t said how many rate cuts would be appropriate. Fed governor Stephen Miran, a former top Trump economist, has forecast that higher productivity implies four cuts this year.
In a post on LinkedIn, Ethan Harris, a former chief economist at Bank of America, said it is clear that Fed officials don’t buy the “golden age argument.” Miran’s call for steep rate cuts met with no support from other Fed officials. In other words, Warsh can expect the same lack of support.
In an op-ed in the New York Times on Tuesday, former Fed Chair Janet Yellen, who was one of the Fed officials urging Greenspan to raise rates, wrote that Warsh is focused on only one side of the AI boom. The other side of the coin is that AI will spark higher demand for business investment and consumer spending, both of which tend to boost inflation and offset the need for any rate cuts, wrote Yellen and Jared Bernstein, a top economist in the Biden administration.
A rocky relationship with markets (at least initially)
It is a mantra on Wall Street that the markets will “test” the new chair with sharp moves lower, said Dario Perkins, managing director of global macro at TS Lombard.
A recent study by a team of economists at Barclays has data showing that new Fed chairs are typically “tested” to some degree by declines in equity prices within the first six months of their appointment to office.
On average, Fed chairs since 1930 have seen a 5% fall in stocks over a one-month period and 12% over a three-month period.
“This does not happen prior to the new appointment landing in the seat … the true test is more likely to come after May if history is any guide,” the Barclays research concluded.
In a note to clients, Perkins said the mantra should be reversed: It is the new Fed chair who tests the market by advocating for tighter policy than expected to establish credibility.
Most famously, the October 1987 “Black Monday” market crash came after Greenspan unexpectedly raised rates, he noted. The White House had installed Greenspan because it thought he would be supportive of easier policy.
“If Warsh does something similar to Greenspan, markets wouldn’t like that. But given the inflation outlook, it wouldn’t be unwarranted,” Perkins said.
Financial markets see no rate cuts this year and have priced in a 30% chance of a hike.
An uphill battle to accomplish the changes Warsh seeks
Two main thrusts of Warsh’s complaints about the Fed are that it has “too big a footprint” in financial markets and is “hyper-talkative,” Michael Gapen, chief U.S. economist at Morgan Stanley, said in a recent Bloomberg television interview.
The footprint refers to the Fed’s $6.7 trillion balance sheet, with holdings of Treasury securities and agency mortgage-backed securities. Warsh’s comments suggested that reducing the balance sheet is a policy priority.
How to shrink the balance sheet must be handled carefully. The Fed relies on ample reserves to set policy rates. If banks feel that reserves are “scarce,” it could be a repeat of the tremendous upward pressure on overnight market interest rates in September 2019, and could stress the financial system. Economists at Fitch Ratings said reducing the Fed’s balance sheet would be risky and the Fed would not move rapidly.
Warsh has a lot more sway on how to cut down on communication. He may hold fewer press conferences than the eight annual sessions Powell held as chair. And he could push his colleagues to stop releasing quarterly economic forecasts that laid out a “dot plot” projected path for interest rates.
Working with those he criticized
Warsh, who is 56, was the youngest Fed governor when he served from 2006 to 2011. Since leaving the Fed, Warsh has been a consistent critic of the central bank. This likely helped him to be tapped by Trump to be Fed chair, but may have made his life at the helm of the Fed more difficult.
Former Fed Vice Chair Donald Kohn noted in an email that Warsh’s criticisms of the Fed since 2011 have been delivered with a “caustic tone.”
Now, Warsh will find himself on the inside again, working with the people he’s excoriated.
“He knows he will need to use his considerable skills to marshal evidence and analysis to support the direction he wants to take policy. I’m hopeful that this process will lead to good outcomes for the U.S. economy,” Kohn said.
Kroszner said Warsh’s objectives to shrink the balance sheet and be more effective in communications are shared by other Fed officials. If the broad objectives are shared, the debate can be about the most effective way to move.
“The Fed staff is going to have the chance to educate the incoming chair on some of the technicalities that might have him rethink some of what he’s written,” Shenfeld said.
