After eight years of friction with the White House, a global pandemic and a battle against high inflation, the US Federal Reserve will usher in a new era, with former director Kevin Warsh soon taking command of the institution.
It will also be a new era for President Donald Trump. He will soon no longer have Jerome Powell, the current Fed chairman, as his favorite punching bag, although Powell will remain on the Fed board. Warsh, Trump’s pick for Fed chairman, will presumably mark a new beginning in relations between the White House and the central bank.
In 2016, Powell had only been in office for the first time a few months when Trump began reprimanding him, angered by the Fed’s interest rate hikes. Now Trump wants rate cuts, and Warsh may also disappoint him due to the risk of higher inflation and the hawkish outlook of other Fed officials.
At the moment, investors predict that Warsh will have to raise rates as early as January.
This is the scenario at the beginning of Warsh’s tenure at the Fed:
Inflation
Trump promised that prices would fall from the beginning of his presidency, but inflation rates show that this has not happened. Between the lingering impact of import tariffs, rising oil prices during the U.S.-Israel war against Iran, and continued strong investment and spending, Warsh takes office at a time when inflation is moving further above the Fed’s 2% target. Several Fed officials have expressed concern about rising price pressures.
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In the Powell years, average inflation was higher than that of his predecessors. But recently, a still-developing ‘disinflation’, or slowing in the pace of inflation, has reversed course following the twin shocks of higher tariffs and rising energy costs.
Unemployment
In addition to controlling inflation, the Fed’s mission is to use monetary policy to keep employment strong. Sometimes the two objectives conflict. Rising prices could require the Fed to tighten monetary policy and put job growth at risk, or high unemployment could require lower interest rates, which risks overheating the economy. The Fed is trying to determine whether this is one of those times of stress.
However, so far, although inflation needs to decrease, the unemployment rate has remained stable and, by historical standards, quite low, at 4.3%.
Proponents of rate cuts have argued that the job market is weaker than it appears, with real risks of a rapid rise in unemployment. However, lately, monetary policymakers have been more concerned about rising prices.
Balance Sheet
The Fed’s set of assets and liabilities is a peculiar economic entity. It includes the country’s gold reserves and all physical U.S. dollars held in banks or stuffed into mattresses. However, most of its current $6.7 trillion in offsetting assets and liabilities is in the form of U.S. Treasury bonds and mortgage-backed securities that serve a dual purpose.
Large balances represent, in practice, Fed money injected into the economy in exchange for Treasury or mortgage bonds. They were accumulated to help the US economy weather crises like the Covid-19 pandemic and are being held as part of the Fed’s toolkit for managing short-term interest rates.
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Warsh is expected to explore several regulatory and monetary policy changes to reduce the large balance sheet. This can lead to a prolonged discussion with limited progress in the short term. Warsh expressed confidence in its ability to engineer broad “regime change,” and Fed watchers may consider the size of the balance sheet as an indicator of its effectiveness.
Success will be influenced by factors such as the US Treasury’s debt issuance schedule or the reaction of international investors to any changes made by Warsh to reduce the balance sheet. Long-term interest rates on U.S. government debt, a factor that influences what consumers pay for home mortgages and other loans, are already rising, and a smaller Fed balance sheet could add further upward pressure.
Interest rates: up, down or sideways?
The Fed has kept interest rates on hold since December, and monetary authorities generally think the current rate of 3.5% to 3.75% is adequate. It is still considered somewhat ‘restrictive’, meaning it puts downward pressure on inflation and reduces overall demand, but not so much that it risks a sharp jump in unemployment. Monetary policymakers also think the current rate could be cut quickly, if necessary, to a level that would keep the labor market stable.
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Some of Warsh’s peers are already worried about high inflation and want to use the Fed’s communication to signal that rate hikes, not cuts, may be coming.
This decision would be an immediate challenge for Warsh, presenting Trump with a shift in language toward a tougher tone at Warsh’s first meeting in June.
But the upcoming debate under the new Fed leader will be broad and may take some time to resolve, covering aspects such as the impact of artificial intelligence on the job market and productivity, and the continued evolution of a workforce constrained by an aging population and immigration levels that have plummeted under Trump.
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