The mixed market reaction to Donald Trump’s nomination of Kevin Warsh as his pick to be the next chair of the Federal Reserve Board highlights the uncertainty as to what his appointment might mean for the Fed and the outlook for US interest rates.
The conflicting opinions on Warsh, and the likely nature of his leadership of the world’s most important central bank were reflected a fall in stocks, a modest risen in bond yields, a stronger US dollar and the biggest plunges in gold and silver prices in decades.
Whether that was all attributable to Friday’s announcement of Warsh’s appointment is debatable. It coincided with a Chicago purchasing managers’ index that showed manufacturing activity in the region expanding, an unexpected but promising departure from a national 10-month trend of shrinking US manufacturing activity.
It could also be argued that the prices of precious metals had been on such a tear – the gold price had soared more than 80 per cent in the past 12 months – that they only needed a pretext for their bubbles to subside abruptly.
Gold fell more than 12 per cent on Friday and silver (which is highly correlated to hold but has a leveraged relationship when gold prices fall) more than 30 per cent.
Nevertheless, the Warsh appointment undoubtedly played a role in the volatility within all the markets on Friday, including the more than 13 per cent slump in the price of Bitcoin.
That’s because, even though he gained Trump’s favour by promising to lower US interest rates (saying anything else would have disqualified him from a job he’s wanted for more than a decade), Warsh, who has previously positioned himself as an inflation hawk, is one of the better-credentialed of the candidates Trump short-listed for the role.
A former governor who Trump considered for the Fed’s chair in 2017 (when he appointed Jerome Powell and has regretted it ever since) Warsh, who has a background in Wall Street, is respected by market participants.
Trump expressed no reservations, saying that he would “go down as one of the GREAT Fed Chairman, maybe the best.” Trump, who tends to make telegenic appointments, also described Warsh as “central casting.”
Given that he could only get the job by promising to lower interest rates, the risk for markets is that he could be just another of Trump’s stooges, compromising the Fed’s independence and its integrity as an apolitical institution in the process.
Alternatively, once in the job – he has to be ratified by Congress and Powell’s term doesn’t end until May – he could risk Trump’s ire and do what the economic evidence dictates.
On paper, Trump’s choice is an odd one.
Warsh has long advocated higher interest rates and a smaller Fed balance sheet, arguing that during and after the 2008 global financial crisis the Fed had exceeded its mandate, fuelled and entrenched inflation, distorted assets prices and exacerbated inequality by keeping rates low and, with its quantitative easing programs (bond and mortgage buying), pumping excess liquidity and credit into the financial system.
It’s only relatively recently – since Trump regained office – that he has begun advocating lower interest rates, arguing that it was possible to have stronger growth with lower inflation and interest rates because of the productivity gains that will flow from artificial intelligence and Trump’s deregulatory policies.
“Fundamental reform of monetary and regulatory policy would unlock the benefits of AI to all Americans. The economy would be stronger. Living standards would be higher. Inflation would fall further,” he wrote in a Wall Street Journal article late last year.
His critics say that Warsh supported lower rates and a smaller balance sheet while Democrats – Obama and Biden – held the White House and controlled Congress. He switched to barracking for lower rates only when Trump was in office and Congress was dominated by Republicans – i.e. his convictions are partisan.
At an institutional level, Warsh has argued for the Fed’s independence of politicians but also for the need for its reforms that would see it relinquishing its role in regulating financial institutions and its interest in climate change and diversity, equity and inclusion programs.
“My reading has it that the Congress granted the Fed independence in the conduct of monetary policy. In my view, no particular deference is owned – no promise of non-intervention due – in the conduct of regulatory policy consumer protection or in other responsibilities granted to the Federal Reserve,” he said in a 2010 speech.
He wants it to focus singularly on monetary policy, narrowing what has, since the financial crisis, become a more expansive role in implementing economic policies. He wants the Fed to be less data-driven and regards the Fed’s forward guidance – its forecasts – as distractions that risk locking the bank into particular narratives.
In other words, if he had his way, the Fed would do and say less and would downgrade its preoccupation with inflation rates and labour markets in a conviction that the productivity miracle that AI is supposed to bring will enable high levels of growth without inflationary pressures.
One of the several conundrums for a Warsh-led Fed is that his support for lower interest rates conflicts with his desire for a smaller Fed balance sheet.
The Fed’s balance sheet ballooned from $US900 billion or so before the 2008 crisis to more than $US4 trillion by the time that crisis was settled, only to surge to around $US9 trillion when the pandemic hit.
Trump will find that inserting his own man into the Fed’s chair doesn’t guarantee that the outcomes that matter will be any different.
Since mid-2022, the Fed’s quantitative tightening program has shrunk it to about $US6.6 trillion, although the Fed resumed some bond-buying last year after short-term funding markets began displaying signs of illiquidity-driven stress.
A smaller balance sheet would mean a tightening of monetary conditions and – by removing the Fed as a buyer from the bond market by either allowing its assets to mature without reinvesting the proceeds, or even selling some of its securities – generating upward pressure on interest rates and risking a seizure within the plumbing of the US financial system.
Warsh’s ability to do anything is also dependent on his ability to convince the seven-member board of governors, and the 12 voting members of an increasingly independent Federal Open Market Committee – the body that actually decides US interest rates and monetary policy more generally — to do as he asks.
He will be only one of 12, albeit the chair has significant influence.
At the moment, Stephen Miran and perhaps the Fed’s Trump-appointed vice-chair, Michelle Bowman, would be the most likely to group with him.
Miran, however, holds a temporary, seat-warming position on the board and his spot might have to be used to get Warsh back onto the board if the Trump administration is unsuccessful in its efforts to use threat of legal action to prise Powell and/or Lisa Cook from their seats.
Powell would have been expected to vacate his seat as a governor in May, when his term as chair expires, following the convention established by his predecessors.
His term as a governor, however, extends to 2028 and the transparent and clumsy threats of criminal prosecution over his testimony to Congress about a blow-out in the costs of renovating the Fed’s Washington headquarters, might cause him to stay on and, perhaps, provide a focus for opposition to Trump’s demand for lower rates.
It’s also the case that, whatever Warsh might be able to convince the Fed to do to the short-term rates where it sets the benchmark, the market will set the longer-term rates that consumers and businesses actually pay.
Trump will find that inserting his own man into the Fed’s chair doesn’t guarantee that the outcomes that matter will be any different. Indeed, if Warsh’s appointment generates conflict within the Fed and doubts about its independence, the move could rebound on him, and Warsh.
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Stephen Bartholomeusz is one of Australia’s most respected business journalists. He was most recently co-founder and associate editor of the Business Spectator website and an associate editor and senior columnist at The Australian.Connect via email.
