Few positions in the world carry as much weight as that of Chair of the Federal Reserve. This is true, of course, because of the scale of the US economy, but also because the dollar serves as the world’s reserve currency. Exchange rates, funding costs and capital flows across much of the globe move to the beat of the Fed’s drum. For financial markets, the Federal Reserve also acts as a safety net in times of stress — the well-known “Fed put”. Arguably, this backstop has dampened risk aversion more than it should, encouraging investors to attempt the financial equivalent of a triple somersault with a double twist rather more often than prudence would suggest. After all, if they misjudge the landing, the outcome has frequently been a relatively soft fall with a sharp rebound.
After months of “will he, won’t he” speculation, Donald Trump has appointed Kevin Warsh as the successor to Jerome Powell, whose term as Chair ends in May. A number of pressing questions inevitably arise: What are his intentions for monetary policy? Will he defer to Trump (if he has been chosen, it must be for a reason)? What will he realistically be able to achieve? Should we be concerned about the independence of the institution he is set to lead? And what impact might all of this have on financial markets?
The workings of the Federal Reserve are far from straightforward — by design, its structure is precisely intended to safeguard its independence. First, Warsh must be confirmed by the United States Senate, and several Republican senators have made their support conditional on an end to what they describe, in no uncertain terms, as the sustained pressure to which Trump has subjected the institution since taking office. Even if Warsh manages to clear that hurdle, space must be made for him. Powell must relinquish the chairmanship, though not necessarily his seat as a governor, should he choose to remain. In that case, it would fall to Stephen Miran — widely regarded as a puppet of the White House (until recently he simultaneously maintained an office there, an unusual arrangement) — to vacate his seat. Such a move would amount to a double setback for Trump’s efforts to exert greater control over the monetary authority.
The institution’s independence would in fact be strengthened in that scenario — something of vital importance. It is often forgotten that a central bank’s most powerful tool is neither its ability to set interest rates nor to print money, but its credibility. To be fair, Kevin Warsh was undoubtedly the candidate who aroused the least suspicion among the final contenders. In any case, at least for the time being, there may be little cause for concern on that front. The Chair of the Federal Reserve holds just one vote out of twelve, and decisions are taken by simple majority. Warsh cannot simply impose his will. He will have to persuade his fellow policymakers if he wishes to lower rates. That will not be straightforward. The economy and the labour market remain resilient, and there will be little appetite for running the risk of inflation slipping out of control again, particularly as it continues to hover above target.
But what does Kevin Warsh actually want to do? He has a reputation as a “hawk”, yet his views appear to shift depending on who occupies the White House — tending towards tighter policy under Democratic administrations and a more dovish stance under Republican ones. He does, however, hold a number of firm convictions. One is that the Federal Reserve is often behind the curve because it waits for the data rather than acting pre-emptively. His current argument, for instance, is that artificial intelligence is on the verge of generating such a leap in productivity that concerns about inflation risk becoming redundant. It is, at the very least, somewhat unsettling to contemplate monetary policy being set on the basis of a “bet” about what shape the future may take. The Fed has not even proved especially adept at predicting its own course of action — the track record between what it has signalled and what it has ultimately delivered is far from reassuring. Moreover, history shows that technological revolutions tend to produce macroeconomic effects in the form of a J-curve: negligible for a prolonged period before eventually becoming visible. That waiting period can be uncomfortably long. Inflation, by contrast, tends to react far more quickly.
Warsh is also convinced that the Federal Reserve has overstepped its mandate by expanding its balance sheet (printing money, in plain terms) to unjustifiable levels, thereby straying into decisions that ought to remain within the political sphere. In his view, lowering interest rates need not be problematic, provided it is accompanied by a simultaneous reduction in the balance sheet — one measure offsetting the other. That will no doubt have sounded like music to the ears of Donald Trump.
If only it were that simple. The problem is that shrinking the balance sheet entails withdrawing liquidity from the system. The safety net we referred to earlier becomes thinner, and the ground increasingly closer. Warsh is also critical of forward guidance (central banks signalling their intended next steps) on the grounds that it shackles monetary policy and reduces room for manoeuvre. Taken together, these positions suggest that volatility would, at the very least, be likely to increase. That, however, may be the lesser concern. The greater risk is that the next acrobatic leap by investors — perhaps the wager on artificial intelligence — ends not in a soft landing but in a painful fall. Warsh has been critical of what he sees as the overuse of monetary policy ever since leaving the Fed in 2011, departing in disagreement over what he regarded as the excesses of the time. But doing and undoing are very different matters. The former is easy. The latter, without breaking something in the process, is anything but. We shall see how adept he proves to be.