By Randall W. Forsyth
Kevin Warsh will face a vastly different economic and financial environment as Federal Reserve chair than his immediate predecessors. Higher inflation and bond yields are likely, given unremitting budget deficits and the likelihood that monetary policy will bend to accommodate federal borrowing needs. That, in turn, would be negative for stocks.
No wonder, then, that there is a record slate of huge technology companies planning to make their initial public offerings while equity markets are at records. At the same time, corporations have started 2026 with a record rush to borrow to take advantage of today's attractive financing terms while they're still available.
Along with the other three finalists for the post to succeed Jerome Powell as head of the central bank, Warsh has endorsed further cuts in the Fed's main policy interest rate. As expected, the Federal Open Market Committee held its target range of 3.50% to 3.75% unchanged at this past week's policy meeting. Dissenting in favor of a further reduction of one quarter of a percentage point were Christopher Waller, also on President Donald Trump's short list, and Stephen Miran, whom the president appointed to the Fed last year.
Warsh has also been outspoken in calling for a reduction in the Fed's balance sheet, one of the central bank's policy tools, which has been used more extensively since the 2008-09 financial crisis, and to fight the economic downturn during the Covid pandemic starting in 2020. As explained back in 2010 by the author of quantitative easing, or QE, former Fed Chair Ben Bernanke, Fed security purchases were supposed to lift bond prices, lower long-term interest rates, and thus stimulate home building and corporate capital investment.
But Warsh and other critics charge that QE has distorted capital market and inflated asset prices as the Fed blew up its balance sheet from about $1 trillion before the financial crisis to nearly $9 trillion in mid-2022. The huge Fed bond buying also supported the massive deficit spending to counter the Covid downturn starting under Trump in 2020 and expanded under President Joe Biden in successive years. All of which led to the surge in inflation past 9% in 2022, to which the Powell Fed responded belatedly with rate hikes and an unwind of QE.
Since September 2004, the Fed has lowered its federal-funds target by a total of 1.75 percentage points. But Trump thinks the Fed's rate target should be slashed to around 1%, based on the notion that the strongest economy should have the lowest borrowing costs -- notwithstanding evidence that ultralow rates almost always go with recession and deflation.
Warsh thinks the Fed can cut its rates because of the potential for artificial intelligence to lift productivity and lower inflation. Lower short-term rates would redound more to consumers and small-to-medium-size businesses, which depend mainly on bank borrowings.
Warsh has said Fed rate cuts could take place in conjunction with shrinking the central bank's balance sheet, which mainly affects the capital markets and intermediate-to-longer-term interest rates. In other words, monetary policy should tilt more to help Main Street than Wall Street.
At the same time, Warsh has endorsed an update of the Treasury-Fed Accord of 1951, which put the Treasury in charge of fiscal matters and left the central bank in charge of monetary policy, as colleague Matt Peterson detailed in his excellent profile of the Fed nominee last year. Warsh would coordinate with Treasury Secretary Scott Bessent on the central bank's securities holdings and the federal government's borrowings.
The massive size of the government's debt is why this seemingly arcane stuff matters. Uncle Sam's interest tab is now running at over $1 trillion annually, more than the defense budget, and rising steadily as old notes with sub-1% coupons are replaced with 3%-plus coupons.
Thus, the Treasury has been emphasizing shorter-term, lower-cost Treasury bills to minimize the rise in interest costs, a policy that goes back to the Biden administration (and was criticized by Bessent before he was Treasury secretary but has been maintained since). More recently, the Fed has been buying T-bills since ending its quantitative tightening, adding $77 billion in bills from Dec. 10 to Jan. 28. That was partially offset by a $30 billion reduction in the Fed's holdings of mortgage-backed securities.
So how does Warsh shrink the Fed's balance sheet while supporting the Treasury's T-bill issuance to finance budget deficits running at nearly 6% of gross domestic product? And if the Fed sheds its mortgage-backed holdings as an offset, what is the effect on the housing market?
Notwithstanding Warsh's principled statements, the central bank will likely accommodate what Société Générale strategist Albert Edwards calls "fiscal incontinence." That will produce a hot economy, according to Jim Masturzo, chief investment officer at Research Affiliates. Nominal growth (real expansion plus inflation) would be boosted, which would help provide the tax revenue needed to service government debt. But, he adds, that points to higher bond yields and more volatility, which aren't good for stocks.
Write to Randall W. Forsyth at randall.forsyth@barrons.com
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(END) Dow Jones Newswires
January 30, 2026 21:30 ET (02:30 GMT)
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