On Friday, Kevin Warsh will be sworn in as the seventeenth Chair of the Federal Reserve Board of Governors, after being confirmed by the Senate in a tight 54-45 vote last week. After a politically contentious end to former Chair Jerome Powell’s term, Warsh must find the just-right policy path to balance economic data favoring monetary cooling and political pressure to turn up the heat.
Since serving on the Board during the financial crisis, Warsh has been known as an inflation hawk. But his tune changed to secure the nod from President Trump, who has not been sheepish about where he wants interest rates: lower. The data make that a difficult deliverable for the newly minted Fed chair.
Inflation remains persistently above the Fed’s two-percent target. According to the latest Consumer Price Index, inflation is 3.3 percent higher than a year ago. Taking out food and piping-hot energy prices due to the Iran conflict still puts inflation at 2.8 percent. And the Producer Price Index, what businesses along the supply chain pay before price pressures hit consumers and show up in CPI, came in at sizzling six percent — the highest since December 2022.
Taken with the recent positive jobs report, the price data has markets thinking rate hikes are more likely by year’s end than cuts. What’s a Warsh Fed to do?
Warsh’s hope had been that a productivity boom from AI would spur enough economic growth to absorb the inflation in the system and allow for the president’s desired interest rate cuts. But there are several complicating factors.
First, the energy price shock and tariffs continue to put pressure on prices. Even if the Fed should look through these supply shocks, the calculus changes when those shocks start changing people’s expectations on the demand side.
Second, price pressures are coming from the demand side. This can be seen in two places. Consumer services prices — which are largely driven by items not directly impacted by tariffs or energy, like shelter, medical services, and auto insurance — are up 3.3 percent. And overall spending in the economy, a good proxy for aggregate demand, is exceeding its neutral level. For both gauges of demand-side pressure, the culprit here is the Fed’s rate cuts in late 2024 and late 2025 — not the latest supply shocks.
Between the Middle East conflict pushing up energy prices, tariff prices being passed on to consumers, and the Fed having pumped more money into the economy, it’s no surprise that inflation and inflation expectations are on the rise.
Importantly, as inflation rises, real interest rates will passively loosen monetary policy — without the Fed doing a thing.
Since real interest rates are equal to nominal interest rates minus inflation, as inflation gets higher and nominal rates stay the same, real rates decrease and ease monetary conditions. For example, if you take the nominal federal funds rate of 3.63 percent and subtract inflation of 3.5 percent (using the Fed’s preferred PCE metric), real rates are a mere 0.13 percent. That’s more than 50 basis points lower than in January. As it stands, the Fed may need to tighten just to stay neutral.
It’s a tough environment for Warsh to be selling rate cuts in, to be sure. It’s an even tougher pitch to convince the President that rate hikes are needed to offset growing price pressures.
Warsh is in a bit of a muddle. But he could turn it to his advantage. The Fed has multiple tools to make monetary policy less easy. Its interest rate target is only one. Another is its balance sheet.
The Fed’s large balance sheet has long been a bugbear to Warsh. He has been critical of the Fed for not having reduced it sufficiently post-financial crisis and giving the Fed an outsized credit footprint in the economy. In an environment where tightening is called for but rate hikes are politically unpalatable, the Fed can shrink its balance sheet. It can do so gradually by resuming its passive quantitative tightening — letting maturing assets roll off, or by selling.
On a spectrum of palatability, selling assets is probably even more sour than hiking rates to both Trump and financial markets. But choosing a passive runoff may be just the solution for an economy in need of monetary tempering, while a president demands low rates and financial markets worry.
If his first monetary decision is between a passive balance sheet runoff or deliberate interest rate hikes, Warsh will be in much less hot water if he chooses the balance sheet path.
Can Warsh convince other Fed officials to come along? Several Federal Open Market Committee (FOMC) voting members already wanted to remove the easing bias in the FOMC statement. With new data showing a steady labor market, inflation starting to scald, a resilient consumer, and strong economic growth, those members may support some tempering using the balance sheet.
At a minimum, as soon as the next FOMC meeting in June, the easing language in the Fed’s statement will likely come out. Signaling a passive balance sheet runoff next would be the simplest step back toward a neutral monetary policy stance and show that Warsh is already delivering on (some) of his promises.
On the other hand, if a Warsh Fed continues the Powell Fed’s “wait and see” approach, it risks repeating the Fed’s late-to-the-inflation-party performance post-pandemic. We already know that the monetary punch is hot. While the president and financial markets might complain that rate hikes are too cold, the Fed should at least water things down by letting the balance sheet run off. If it waits, the alternative will be a bucket of ice in massive rate hikes like Powell dumped in 2022. Warsh should prefer to cool the punch bowl down now before he’s forced to whisk it away.
