By Brij Khurana
About the author: Brij Khurana is fixed income portfolio manager and senior managing director at Wellington Management.
In his rise to the top of the Federal Reserve, Kevin Warsh cast himself as a change agent, pledging to "lead a reform-oriented" central bank and abandon "static frameworks and models." That is long overdue.
The U.S. economy has changed profoundly since the pandemic, yet the Powell Fed appeared reluctant to change in step. Its mantra of "data dependence," for instance, was ill-suited to modern challenges. Its forward-guidance wasn't always helpful -- in Warsh's opinion, i t was actually damaging.
Warsh will have to address more structural issues, too. He must rethink long-held assumptions about monetary policy and consider: How should the Fed respond to the declining effectiveness of monetary policy itself?
Economists have traditionally believed that monetary policy influences the business cycle primarily by encouraging or discouraging investment. Investment is highly sensitive to interest rates: When the Fed wants to slow the economy, it raises rates, dampening investment, growth, and inflation.
But the enthusiasm for artificial intelligence has, so far, made capital expenditures relatively immune to higher rates. At the same time, higher rates can do little to calm today's inflation volatility, which largely originates on the supply side of the economy. The Fed's tools are better suited to manage demand-driven inflation than inflation caused by supply constraints.
Monetary policy is also becoming less effective in shaping longer-term interest rates. Historically, when the Fed cut short-term rates, long-term yields declined as well. That is no longer true. Since the Fed began its ongoing easing cycle in September 2024, 10-year Treasury yields have actually risen. This reflects resilient economic expansion and a fiscal deficit that has grown so large as to mute the effects of the cuts.
Given these changes, it is worth considering whether the Warsh Fed should prepare markets for more forceful and less predictable rate adjustments ahead.
A related consideration is how monetary policy should interact with fiscal policy in an era of a structurally large federal deficit. President Donald Trump has made clear that he wants lower interest rates to reduce the government's financing burden. The Fed typically avoids acknowledging the extent to which monetary policy incentivizes government borrowing, preferring to defer fiscal matters to elected officials.
The Fed routinely considers excessive leverage in the household and financial sectors as a potential systemic risk, however. Government debt, especially at a stratospheric level, can create systemic risk in the same way.
The federal debt complicates the Fed's ability to achieve its dual mandate of maximum employment and price stability. If foreign investors, who finance a third of U.S. debt, trim their Treasury holdings and the Fed responds by expanding its balance sheet, the dollar could weaken, fueling inflation.
Heavy Treasury issuance creates distortions between government bonds and derivatives linked to them. Hedge funds use substantial leverage to arbitrage these discrepancies. An estimated $1.5 trillion of such trades are outstanding, posing a risk to financial stability. Finally, government spending has helped lift equity markets, supporting wealth-driven consumption and keeping services inflation persistently high.
So what is the path forward? Perhaps the Fed should shrink its balance sheet so the real cost and liquidity of government debt can be fully known. Maybe it should use interest-rate and balance-sheet policy to lean against debt-fueled asset price appreciation, regardless of where that debt originates.
The Fed may also need to reconsider how it measures success in achieving its dual mandate. Tighter immigration policies and retiring baby boomers are decelerating labor-force growth, and advances in AI are reducing labor demand. Does a stagnant labor market, as marked by a low unemployment rate, constitute genuine economic strength? Or should the Fed place greater weight on other indicators of labor-market health like real wage growth, which has fallen 0.7% over the past year?
The same question applies to inflation measurement. Nearly a third of the consumer price index is tied to housing costs, yet the housing market remains frozen due to supply issues. The CPI's shelter index increased just 3.4% year over year in May -- nearly a percentage point lower than the broader CPI reading. Is the sector still an accurate barometer of broader inflationary pressure?
These are difficult questions that go to the heart of monetary policy and the Fed's role in the economy.
In recent years, the central bank's answer to these questions has largely been data dependence -- using contemporaneous data to determine whether policy is overly restrictive or accommodative. But monetary policy operates with long and variable lags. Excessive reliance on backward-looking data could leave the Fed perpetually behind the curve. Nor does data dependence adequately acknowledge the extent to which the Fed itself shapes economic behavior through interest-rate policy and the management of its balance sheet.
Warsh has an opportunity to adapt the Fed to the realities of today's economy. His challenge isn't simply to lead the world's largest central bank, but to rethink how it should operate in a structurally different economic era.
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June 12, 2026 06:00 ET (10:00 GMT)
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