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The writer is chief market strategist at Jefferies
The naive market narrative about Kevin Warsh suggests that he has traditionally been a policy hawk who suddenly turned into a dove for political reasons. However, that is a very flawed analysis.
It ignores the salient points of the Federal Reserve chairman-designate’s likely low-interest policy framework. In particular, Warsh has long had a supply-side bias on what drives economic growth, and he has indicated a willingness to make explicit trade-offs between balance sheet size and interest rate levels when setting monetary policy.
Let’s first discuss Warsh’s approach to macroeconomic analysis. When a supply side like him sees strong economic growth, without significant increases in employment or wages, the tendency is to worry more about disinflation than inflation.
While an old-fashioned Keynesian would harp on about the ‘overheating’ of the economy and the need for monetary policy tightening, a neoclassical supply side would focus on ‘productivity’ and the risk that creative destruction in labor markets would actually require monetary policy easing.
Warsh will have powerful supply-side ammunition when it comes to advancing a lower interest rate thesis around the table at the Federal Open Market Committee, as strong growth has coincided with rising unemployment.
But he will have to argue against the current Fed staff models used to analyze the economy. These behemoths have their roots in deeply flawed Keynesian concepts from the 1960s and 1970s about relationships between economic variables such as the Phillips curve and Okun’s law (see the outcome of ‘ferbus’, also known as the FRB/US staff model, or as I like to call it ‘ferbuseless’). A forced dismantling of such flawed instruments would help legitimize Warsh’s agenda.
As for the Fed’s balance sheet, Warsh has historically argued for a much lower level. More recently, however, he has neutralized this hawkishness with support for explicit easing via lower interest rates. As someone who has long argued that one should never talk about a neutral interest rate structure without first outlining the parameters of a neutral balance sheet level, this is very welcome. The details of his trade-off have not yet been released, but as an opening salvo you can imagine a cut of about 0.75 percentage points for every $1 trillion balance sheet reduction.
Bringing such a debate to the FOMC table would be a huge step forward. The central bank’s downplaying of any important role for the balance sheet in calibrating the stance of monetary policy led to a complete misjudgment of the level of stimulus remaining in the system during the 2022-2023 rate hike cycle. And that, in turn, led to huge miscalculations about the impact of those interest rate increases on the economy.
There will of course not only be internal resistance to an explicit policy on interest versus balance sheet. The holding companies of the major banks, through their control of the New York Federal Reserve, have cracked down on a low interest rate/low balance sheet approach to monetary policy. These people love the extra margin on their interest income that comes with higher interest rates, and they love the large interest payments that come with more excess reserves at the Fed.
But the Fed chairman has many powerful tools to effect change both internally and externally. Internally, Warsh can increase the power of his comrades and dismantle the existing power of his opponents on the FOMC committee. There are many chess pieces he can play in the areas of supervision, regulation, international affairs and financial stability, to name a few. And he can use the candy from his deregulatory bag of goodies to get the big banks on his side. Once there, those bank people can also be quite convincing in taking on stubborn committee members.
Warsh’s ability to navigate this complex political game and take eleven other FOMC members along for a ride at a low fare will be the ultimate test of his ability to be a successful chairman. I bet he has the skills to pull it off.
As such, Donald Trump will soon no longer have Jay “Too Late” Powell to insult after every FOMC meeting. Instead, he’ll have Kevin “Low Rate” Warsh to cheer on as he moves to assemble the wily squad of committee members. Ultimately, I fully expect a lower interest rate/lower balance sheet for monetary policy, which in turn will bring some much-needed relief to Main Street, while keeping the Wall Street party afloat.
