Kevin Warsh walks into a trap where the Fed can't cut rates even if it wants to

MW Kevin Warsh walks into a trap where the Fed can't cut rates even if it wants to

By Felix Vezina-Poirier

The energy shock and a heated economy strip the new Fed chief of his power to support stocks and bonds

Fed Chair Kevin Warsh faces more constraints than investors expect.

Kevin Warsh is becoming Federal Reserve chair at a pivotal moment for the U.S. economy - forcing him to be something other than the disruptor he hoped to be.

Two limitations matter most. The first is the big-picture backdrop: U.S. economic growth and employment have stabilized and inflation is becoming a market concern. Second, the Fed's deeply embedded policy framework is built around risk management, rather than any single inflation measure or economic school of thought.

These constraints mean Warsh may have less room to cut rates and reshape policy than either he or Fed observers expected. (Indeed, federal-funds futures are currently pricing in no rate cuts at all this year.)

Constraint No. 1: The macroeconomic backdrop

The case for lowering rates before the Iran war started rested on two arguments: Tariff-driven inflation would pass through the economy, and the labor market was weakening. Both of these arguments have become less straightforward.

Tariff pass-through was still visible in inflation reports before the Iran war, which partly motivated the Fed to hold rates. The Iran war energy shock has now created a renewed inflation impulse that will persist for a few months. March and April data show that energy-driven inflation is spreading to consumer and producer prices, but the full extent of the pass-through and potential second-round effects remain unknown.

One way to assess inflation shocks is to separate direct effects, indirect effects, second-round effects and the impact on real incomes. The direct effect comes from higher energy prices. The indirect effect comes as those costs spread through transportation, manufacturing and goods prices. The second-round effects are what matter most for the Fed: inflation expectations, mainly through wage growth and companies' selling prices.

For now, long-term inflation expectations remain anchored. That means it is too early to discuss rate hikes, which markets have recently started to price in. As long as inflation expectations stay anchored, the Fed can afford to look through the shock, although that could change if expectations de-anchor.

At the same time, the U.S. labor market looks better than it did a few months ago. Job growth has slowed considerably over the past year, in part due to demographics and immigration restrictions. The decline appears to have stalled, with job growth picking up again and both worker and business sentiment improving at the margin.

That resilience is worth noting. If it continues, it would fuel inflationary pressures. It also changes how markets react to data.

When growth is the focus, both stock prices and bond yields usually move together. Stronger growth data are good news because they point to stronger earnings and demand.

When inflation is the focus, stocks and bonds often move in opposite directions. Stronger growth data can become bad news because they imply tighter policy. Weaker growth data can become good news because they imply less inflation and less policy drag down the line. This creates a backdrop where resilient data could actually hurt equities.

Macro-data resilience helps explain why bond yields have risen in recent weeks. Growth and inflation have both held up better than when rate cuts were priced. The next few weeks could therefore see good economic news hurting markets.

Constraint No. 2: The Fed's risk-management framework

Among other reform ideas, Warsh has discussed changing how the Fed thinks about inflation, including greater emphasis on "better" measures such as the Dallas Fed's trimmed-mean personal consumption expenditures index. That change would likely be cosmetic at best.

For all the debate about frameworks and economic schools of thought, the most important intellectual work done by central banks is risk management. Monetary policy does not depend only on one theory of growth and inflation. It also weighs upside and downside risks. In other words, the tails matter, not just the belly of the distribution.

Unless the Fed abandons that risk-management framework, focusing on a narrower inflation measure would not materially change policy if inflation risks are skewed one way or another. During the inflation flare-up after the COVID pandemic, trimmed-mean inflation lagged headline measures. Using it as the main guide would have delayed the Fed's policy response even further.

Inflation expectations depend on many factors, including central bank credibility. A central bank signaling that it will not address upside inflation risks because one specific measure is moving toward its target would send the wrong message.

That is the deeper and longer-term constraint Warsh will face. He can argue for a different measure or a different framework, but the Fed's job will still be to manage risks around inflation and employment.

What this means for investors

Whether Warsh will turn out to be hawkish or dovish is difficult to say, but the U.S. dollar DXY is likely to face headwinds either way.

If Warsh ends up too dovish, which would be hard to do given that monetary policy is decided by committee, real yields will fall, weighing on the dollar. If Warsh instead reverts to the hawkish instincts he has historically shown, it would act as a constraint on fiscal policy.

That matters because loose fiscal policy has been an underdiscussed driver of American exceptionalism in recent years. It has helped the U.S. outperform its developed-market peers. A reversal of loose fiscal policy would hurt U.S. growth in the medium-term, which would also weigh on the dollar.

Yet no single currency can replace the dollar. That means investors will have to build exposure to the dollar's properties synthetically, through a basket of other currencies. The euro (EURUSD), Canadian dollar (CADUSD) and Australian dollar (AUDUSD) stand to benefit over the long run.

Markets should also prepare for volatility from higher rates. Sparser Fed communication could create a period of larger swings as markets transition to a world where the central bank does less to tame policy uncertainty.

The six-to-12 month outlook for financial markets is deteriorating as inventories fall, inflation risks rise and higher capital costs become more relevant for the AI capital expenditure boom. The portfolio implication is to tactically maintain risk exposure while adding hedges and favoring energy, healthcare, industrials and materials over consumer sectors.

Felix Vezina-Poirier is the chief strategist for Daily Insights, BCA Research's global cross-asset strategy service. Follow him on LinkedIn and X.

More: Trump tells Warsh 'to be totally independent' as Fed chair. Some doubt whether he means it.

Also read: The oil shock meets the Fed 'curse': What Kevin Warsh's swearing-in means for your portfolio

-Felix Vezina-Poirier

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May 22, 2026 16:01 ET (20:01 GMT)

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