Untangling the ideas of Donald Trump’s Fed nominee

Few consider the Federal Reserve to be an all-singing, all-dancing body. But Kevin Warsh did manage to talk a fellow Fed governor into belting out a musical number at his first meeting in 2006. In the years since, Mr Warsh has mostly sung a consistent refrain: that inflation was perilous, monetary policy often over-stimulative, and Fed bond-buying at the root of many of America’s economic woes.

Lately Mr Warsh’s tune has changed. The inflation hawk of old seems to have swapped his feathers. That metamorphosis helped him get the nod from the president, who is desperate for lower interest rates. After years as a dissident, Mr Warsh is set to run the world’s most important central bank. He has called for no less than “regime change”. What exactly that means looks hazy, but Mr Warsh’s 20-year-plus record of Fed critique offers hints for what America, and the world, should expect from Warshonomics.

Start with the core job of any central banker: steering interest rates. Statutorily, the Fed follows a “dual mandate”: to balance low inflation with a healthy jobs market. For most of his career, Mr Warsh has been adamant that inflation comes first. “If price stability is squandered, financial stability is put at risk. If financial stability is lost, the economy is imperiled and the social contract is threatened,” he wrote in 2021.

Accordingly, Mr Warsh has usually sided with the inflation-crushing hawks. The Economist used an artificial-intelligence (AI) model to place nearly 200 of his speeches, television appearances and papers on a “hawk-dove” spectrum. Before this year, the only times he veered into doveishness were during serious scares: the global financial crisis of 2007-09, the covid-19 pandemic and the collapse of Silicon Valley Bank in 2023 (see chart). That was until Donald Trump won a second term. Since then he has called for rate cuts repeatedly, forcefully and out of keeping with his younger self.

What has changed? An imminent productivity boom courtesy of AI and Mr Trump’s deregulatory zeal. These, Mr Warsh argues, will squash inflation. He fears high rates could strangle resulting growth. Yet even if productivity surges as he predicts, which is uncertain, the thesis is flawed. Though higher productivity lets the economy grow faster without lifting prices, once inflation does rear its head—and today inflation remains above the Fed’s 2% target—higher rates are needed to squeeze demand. Second, productivity gains usually drive higher investment, which raises the “neutral rate”: the theoretical level at which Fed policy is neither easy nor tight. Lowering rates as that baseline rises could over-stimulate the economy, turbocharging inflation.

If Mr Warsh has flip-flopped on rates, he has been resolute on the main villain in American monetary policy: the Fed’s ballooning, multitrillion-dollar balance-sheet. The conventional debate about quantitative easing (QE), finance-speak for buying bonds with newly printed money, tends to focus on whether it has a small impact or none. Mr Warsh stands out for the scale of the sins he lays at QE’s door: government profligacy, misallocated capital, higher inequality, diminished Fed independence, a more fragile banking system and sagging productivity. Some of those allegations are plausible, others less so. All are overwrought.

To reduce the imprint on the economy he believes QE to have left, Mr Warsh wants to shrink the Fed’s balance-sheet. That goes against the Fed’s recent decision to end quantitative tightening (shrinking the balance-sheet by letting holdings mature). Were Mr Warsh to begin offloading bonds, the immediate effect would be to lower prices and push up yields. Those yields determine key interest rates in the economy, including those of mortgages. Mr Warsh’s plan would be to offset those rises by cutting short-term rates. The upshot would be a steepening of the yield curve, as the gap between long-term borrowing costs and short-term ones widens. Getting the balance right would be a delicate dance, not least because the effect of Fed purchases on bond yields is uncertain.

Should he succeed, another issue would emerge. The mirror of the Fed’s bond holdings are the reserves held by banks, which the Fed issued to buy the bonds in the first place. Since the financial crisis, those reserves have become the main tool for setting interest rates. Leave too few reserves and the market for overnight bank borrowing could become chaotic, repeating, on a bigger scale, the “repo” liquidity crunch of 2019.

Then there is the most naked dimension of the “regime change” that Mr Warsh proposes: remaking the Fed itself. The bank has made mistakes in recent years—it was caught offguard by the post-pandemic surge in inflation. Some of Mr Warsh’s criticisms, such as the notion that central banks should steer clear of politicised terrain such as climate change and racial justice, are sensible. But others are questionable. Mr Warsh has accused the Fed of being too reliant on data in general and too wedded to antiquated government statistics in particular. But without credible figures to track the economy, all that is left is unfalsifiable speculation on future productivity booms and similar conjectures. And the private providers of data he is promoting are still a long way from superseding official ones. Just ask stockmarkets, which still surge or sink on payroll or inflation releases.

As Fed chair, Mr Warsh will have three audiences to please: Donald Trump, financial markets and his fellow rate-setters at the Fed, a technocratic bunch whose votes he will need to get anything done. Mr Trump dearly covets lower interest rates; markets are increasingly leery about American assets; and his peers at the bank will hamstring his tenure if he gets too political. To keep everyone clapping, Mr Warsh will need to turn in the performance of a lifetime. ■