The next Federal Reserve Chair, Warsh, secured his nomination with a dual policy agenda of interest rate cuts and balance sheet reduction. However, the economic environment he is about to inherit is simultaneously undermining the feasibility of both objectives.
An unexpected resurgence in inflation has significantly dampened the Fed's internal willingness to cut interest rates, while the resilience of the labor market has also diminished the urgency for accommodative policies. Currently, average futures market pricing indicates that traders do not expect any rate cuts in 2026.
Simultaneously, on the issue of reducing the size of the balance sheet, the Fed already has precedents showing that even a gradual tapering can trigger bond market turmoil, making the process challenging.
Warsh has been confirmed by the Senate through a party-line vote, but the exact timing of his formal swearing-in remains unclear. He will inherit a monetary policy environment that significantly diverges from his initial policy assumptions.
Inflation Pressure Coupled with Labor Market Resilience: The Window for Rate Cuts Has Narrowed
When Warsh was nominated in January, most of his future colleagues still viewed rate cuts as a matter of timing. However, this backdrop has shifted rapidly.
The outbreak of the Iran war in late February drove energy prices sharply higher, pushing overall inflation upward. This has made any central bank's decision to cut rates increasingly difficult. The European Central Bank and the Bank of England have both warned they may shift to rate hikes this year.
During his Senate confirmation hearing, Warsh hinted he might advocate for the Fed to give more weight to alternative inflation measures, which have shown relatively moderate recent readings. However, whether this strategy can gain majority support within the Committee in the current environment remains uncertain.
Trends in the labor market have further weakened the rationale for accommodative policy.
A weak February jobs report initially heightened market concerns about rising unemployment, but subsequent data for March and April showed the labor market has not lost momentum, with unemployment remaining low.
Warsh previously justified rate cuts by citing productivity gains from artificial intelligence. However, the persuasiveness of this argument has significantly diminished in the current inflationary environment.
Balance Sheet Reduction Dilemma: Extremely Limited Room for Maneuver
Warsh has long criticized the Fed's balance sheet as excessively large. The Fed expanded its balance sheet massively during the 2008-2009 financial crisis and the pandemic, with assets peaking near $9 trillion in 2022 and currently standing at approximately $6.7 trillion.
Reducing the asset side requires a corresponding compression on the liability side, and the Fed's liabilities are crucial for the smooth functioning of the economy.
Among the Fed's main liabilities, deposits from the Treasury in its account at the Fed and physical currency are largely outside the Fed's direct control. The overnight reverse repurchase facility, which once exceeded $2 trillion, has been nearly exhausted during the previous tapering cycle.
Consequently, the only substantial room for reduction lies with bank reserves. The Fed has complete control over reserve supply, and most balance sheet reduction plans target this liability item.
However, last fall's experience clearly revealed its fragility: a modest decline in reserves triggered intense anxiety in the bond market, forcing the Fed to quickly reverse course and resume reserve expansion. This indicates that Warsh's balance sheet reduction plan not only faces internal policy disagreements but must also confront unpredictable market risks.
Internal Divisions: Consensus Is Hard to Sustain
Leading the Fed means building consensus among the eleven other officials who also have a vote on interest rates. If Warsh pushes for rate cuts or balance sheet reduction, he is likely to encounter resistance from his new colleagues, one of whom is the outgoing current Chair, Powell.
For most of Powell's tenure, Committee decisions were characterized by consensus. However, over the past year, divisions among voting members have noticeably intensified.
At the most recent meeting in late April, the Fed held rates steady, but four officials dissented. Three of them believed the Fed should begin signaling that the likelihood of rate hikes and cuts is becoming more balanced.
In their quarterly projections for the interest rate path, officials' median forecast in March was for just one rate cut this year and another next year. This forecast will be updated at next month's meeting.
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