CICC has released a research report analyzing the potential reforms proposed by Federal Reserve Chair nominee Kevin Warsh. The report indicates that Warsh is advancing his monetary policy framework reform through five working groups, aiming to establish a new system that facilitates the directional allocation of liquidity through coordination with fiscal policy and the banking sector. This approach, which Warsh has repeatedly emphasized as "monetary-fiscal coordination," is designed to channel funds away from financial speculation and toward the real economy.
Under the proposed new framework, Warsh's reforms seek to institutionalize the reduction of financing costs, align with fiscal objectives, and direct capital to areas of greatest need. As the U.S. government and strategic industries become increasingly reliant on debt financing, CICC believes monetary policy will be forced to adopt a trend of accommodating both price and quantity. The report forecasts the following adjustments to the monetary policy framework: Regarding policy interest rates, the focus will shift toward endogenous inflation driven by the economic cycle—such as wage growth—which monetary policy can and should manage. This will downplay structural inflation caused by systemic shocks like geopolitical conflicts and the AI investment boom. Consequently, this would raise the bar for rate hikes while lowering the threshold for rate cuts. Additionally, as fiscal financing becomes more dependent on short-term debt, policy rates will increasingly factor in the burden of debt interest payments, rather than being determined solely by economic fundamentals.
On the balance sheet front, the Federal Reserve would transition from the QE/QT era of active liquidity management to a passive role of expanding its balance sheet in coordination with fiscal policy and banks, thereby injecting base money. Specifically, it would cooperate with the Treasury Department's issuance of short-term debt by continuing to use the Reserve Management Purchase (RMP) operation to trendwise buy short-term bonds for expansion. Simultaneously, deregulation of the banking sector would incentivize banks to increase their utilization of Federal Reserve credit tools, thereby activating bank lending and Treasury market-making functions, and freeing up banks' duration capacity. In summary, CICC
Problems with the QE/QT Liquidity System
The U.S. dollar liquidity framework established after the 2008 financial crisis, where the absolute level of bank reserves (narrow liquidity) remained "ample," has three major structural issues. First, on the source of liquidity, the "big bang" approach to liquidity can easily lead to excessive financial speculation and risk accumulation. Prolonged QE actively releases large amounts of liquidity quickly, often leading to overly loose conditions and speculative froth, which is then followed by aggressive QT overcorrection, ultimately causing liquidity or even financial risks that trigger a new round of QE. Second, regarding interest rate and communication policies, the continuous, high-frequency communication with markets creates a feedback loop between market expectations and Fed policy, where any unexpected tightening can spark market volatility or financial risk, forcing the policy to eventually pivot back to a dovish stance (the so-called "Fed put"). Third, on the subject of regulation, banks are over-regulated by requirements like the Supplementary Leverage Ratio (SLR), Liquidity Coverage Ratio (LCR), and Intraday Liquidity Monitoring, which severely limit their ability to stabilize financial markets (market-making) and expand credit. Meanwhile, non-bank entities such as hedge funds lack effective supervision, allowing them to leverage up and create risks that are harder to observe.
Structural Constraints Facing Warsh's Reforms
Given the issues with the old system, reform appears inevitable. Since his nomination, Warsh's frequent signals of balance sheet reduction have rattled markets. However, CICC assesses that this "balance sheet reduction" is not the same as in the past. Warsh faces structural constraints from fiscal, economic, and market dimensions that make a simple "reduction in the nominal size of the Fed's balance sheet" difficult to achieve; these constraints might even force monetary policy to be more accommodative. First, the "small government" era has ended, and "big fiscal" has returned, creating immense pressure for U.S. Treasury financing. The trend of "prioritizing monetary policy over fiscal policy" since the 1980s has been accompanied by industrial hollowing, financialization, and wealth inequality, which have sparked strong public backlash since the 2008 crisis. The recent rise of pro-cyclical, big fiscal policies is driven by strong needs for national security, functional industrial policy, and redistribution. Looking ahead, even under the conservative CBO baseline, elevated deficit ratios are expected to persist, imposing hard constraints on monetary policy from both a price and quantity perspective regarding Treasury issuance, making it difficult for monetary policy to tighten substantially and potentially requiring expansion to support fiscal needs.
Second, there is the financing pressure from AI and reindustrialization investments. Betting on AI investment to boost productivity, drive reindustrialization, and address geopolitical challenges has become a global policy focus. CICC believes this means the AI-driven boom may transcend typical economic cycles, and as companies' free cash flow is depleted, investment will increasingly rely on financial market financing. The corresponding increase in bank market-making and credit demand means that overly tightening the cash (reserves) held by banks would hinder this financing and could even trigger liquidity risks. The inherent fragility of the financial system itself dictates that liquidity reform must be cautious. Mainstream central bank research suggests that the minimum size of a central bank's balance sheet is determined by the financial system's minimum demand for reserves. Currently, reserve levels are already relatively insufficient, as evidenced by the repo market stress during the Treasury issuance surge in mid-2024, which forced the Fed to start RMP for balance sheet expansion.
Warsh's Countermeasure: A New Type of "Monetary-Fiscal Coordination"
In response to these constraints, CICC observes that Warsh is pursuing a reform path of "breaking the old to establish the new." This involves criticizing old rules, creating new ones, and building independence on a new rule-based foundation. Adhering to these new rules would naturally satisfy the aforementioned financing constraints and financial stability requirements without allowing monetary policy to become overly tight. This is reflected in the setup of his working groups on the inflation framework, economic data, and productivity/employment. The Inflation Framework Working Group, led by economists like Thomas Sargent and N. Gregory Mankiw, suggests that inflation is a result of both fiscal and monetary policy, and that if fiscal deficits spin out of control, monetary policy alone cannot contain inflation. They advocate for targeting a range of inflation or re-anchoring expectations to wage levels, especially in a K-shaped economy where investment inflation coexists with wage disinflation. The Economic Data Working Group, led by Raj Chetty, argues that traditional aggregate macroeconomic data masks structural differences. By using micro-level big data, the true economic temperature of different classes and regions can be observed, suggesting that the resilience of the traditional U.S. economy may not be strong enough to withstand sustained tightening. The Productivity and Employment Working Group, led by an economist, emphasizes the potential for AI-driven long-term supply-side productivity gains to lower costs and suppress inflation, arguing for more patience with this supply-side disinflationary force rather than stifling its investment needs through traditional tightening.
Liquidity Injection Mechanism: From Fed Activism to Supporting Fiscal and Bank Needs
The old QE/QT model of excessive looseness and tightness does not meet the goal of providing a stable monetary backdrop. To adjust the liquidity framework, Warsh's approach, as detailed by the Balance Sheet Working Group and a guide by then-Fed Governor Christopher Waller, involves several core changes. First, the method of liquidity release would end the QE/QT model, becoming passive, granular, and routine. Liquidity injection would shift to a model where fiscal authorities, banks, and other foreign institutions take the initiative, and the Fed plays a passive, accommodating role. For the Treasury, during periods of debt issuance that drain reserves, the Fed would purchase Treasury bills to inject an equivalent amount of liquidity. For banks, the "stigma" associated with the discount window and Standing Repo Facility (SRF) would be removed, and borrowing terms would be extended to encourage banks to borrow routinely for their cash needs. This would essentially allow the Fed to accommodate bank balance sheet expansion for base money injection. Second, the balance sheet's duration would be reduced, with the Fed holding more short-term debt and releasing long-term bonds to banks and other financial institutions. Warsh's criticism of QE focuses on its distortion of asset pricing from long-term bond purchases. However, this "balance sheet reduction" must consider the market's absorption capacity, as any financial risk could force the Fed back into buying long-term bonds. CICC believes Warsh might achieve duration reduction through a "duration swap"—continuing to sell MBS and buy short-term debt, thereby shortening the overall asset duration. Third, bank deregulation would be crucial to increase their capacity and willingness to hold bonds. By lowering liquidity and capital requirements, such as the Liquidity Coverage Ratio, banks would reduce their cash holdings in favor of higher-yielding assets. If they can pledge Treasury bonds at the SRF or discount window for stable, long-term refinancing, they would have an incentive to arbitrage by buying long-term bonds, financing them through the window, and earning the spread, thereby increasing demand for long-term bonds and potentially stabilizing or lowering long-term rates.
A New Form of "Monetary-Fiscal Coordination"
Based on this reform blueprint, Warsh is effectively implementing a new, more subtle form of monetary-fiscal coordination. Unlike the Trump administration's relatively direct, executive-order-based approach of pressuring Fed independence, this new form is built on rules and institutions. In terms of interest rate policy, with the new inflation and economic data anchors and consideration for long-term supply efficiency, the Fed could potentially choose not to raise rates during periods of commodity inflation driven by geopolitical conflict or investment booms while wages are disinflationary. It could still cut rates when oil issues subside. On the quantity policy side, this approach prevents the "big bang" of liquidity while ensuring a smooth, marginal channel for fiscal and financial institutions to access funds. The result would be continued balance sheet expansion by both the Fed and banks, with a smoother and more precise liquidity injection channel. Regarding financial regulation, deregulating banks increases their capacity to expand, while shifting their supervisory responsibilities to the Treasury. This monetary-fiscal coordination, with banks expanding under Treasury oversight, would enable banks to act as market makers for Treasury issuance or to direct credit to the real economy according to industrial policy, effectively providing the financial tools for a "big fiscal" state to achieve its goals of de-financialization and reshoring manufacturing.
CICC cautions that even under the new framework, the Fed's role as "market maker of last resort" (MMLR) cannot be shirked. If this monetary-fiscal coordination framework is implemented, lowering short-term rates to stimulate the economy could lead to a rise in long-term bond yields if the yield curve steepens. In such a scenario, without direct Fed intervention or an implicit guarantee, relying solely on private financial institutions to absorb U.S. Treasury debt might be insufficient to effectively cap long-term yields and prevent a stampede in risk scenarios. Warsh himself opposes only the normalization of QE, not the provision of emergency liquidity through QE during a crisis. Therefore, the Fed would still need to serve as the MMLR.
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