Washington’s three major challenges: the Federal Reserve, inflation, and Trump

Kevin Warsh has spent the past 15 years severely criticizing the Federal Reserve for being too large, for poor inflation management, and for its compromised independence. Now, as Trump’s nominee for the next Fed Chair, he will have to personally confront and solve these problems. On January 31, Greg Ip, chief economics commentator for The Wall Street Journal, pointed out in an article that if confirmed, Warsh will face three tricky balancing acts: **Shrinking the Federal Reserve’s balance sheet without disrupting markets, bringing inflation back down and stabilizing it at 2%, and avoiding presidential interference that could erode central bank independence in the process.** Each task is far more difficult than it sounds. ## **Reducing the “institutional swelling” of the Federal Reserve** Warsh served as a Fed governor from 2006 to 2011 and helped respond to the global financial crisis under Ben Bernanke. He eventually resigned in opposition to the “quantitative easing” (QE) policy. QE works by buying trillions of dollars in bonds and injecting reserves into the banking system to lower long-term interest rates. From 2008 to 2022, the size of the Fed’s balance sheet expanded from **$900 billion to $9 trillion**. Although it has dropped somewhat, it remains at **$6.6 trillion, which Warsh still sees as excessively large.** Warsh believes this policy distorts market signals and encourages fiscal deficits, ultimately driving up inflation. > “Every time the Fed intervenes, it expands its size and power,” he said last April. “Debts keep piling up, capital allocation becomes ever more distorted, and institutional boundaries are crossed time and again.” This viewpoint has been echoed by Treasury Secretary Scott Besant, who has accused the Fed of “mission creep” and “institutional bloating.” But reducing the balance sheet comes at a cost. First, banks now rely on ample reserves to maintain funding and smooth market operation. For this reason, the Fed halted further shrinkage of its balance sheet late last year. Second, selling bonds could push up long-term yields and in turn raise mortgage rates—which would directly anger Trump, who favors low interest rates. ## Inflation theory and internal “regime change” Warsh’s nomination comes as US **core inflation remains close to 3%**, far above the Fed’s 2% goal. He must propose ways to bring inflation down, and persuade the 12-member Federal Open Market Committee (FOMC) to adopt them. Unlike Powell, who has an economics background, Warsh is trained in law and finance. He often disparages mainstream macroeconomic models and the “economic guild” behind them, **preferring to explain inflation using commodity prices, stock prices, money supply and other indicators.** This unorthodox view has raised concerns about conflict within the Fed. Warsh has hinted at the need for thorough Fed reform, bluntly stating last July: > **“What we need is regime change at the Fed… This isn’t just about the chair, but about a group of people. We have to break old structures, even ‘break some heads.’”** Former Fed Vice Chair Don Kohn points out that while he agrees with some of Warsh’s criticisms, he disagrees with his “harsh tone.” However, Nellie Liang, a former Fed staffer, believes Warsh may prove more inclusive than his words suggest: he won’t be bound by staff models, but also won’t completely ignore professional advice. For markets, Warsh may have some luck in the near term, since easing tariffs and housing pressures should help inflation fall this year. But if the winds shift, Warsh will need to come up with an inflation theory that can persuade both the markets and his FOMC colleagues. ## Who can say “no” to Trump? Warsh’s supporters argue he is more independent than his rival, White House adviser Kevin Hassett. In reality, however, his nomination comes from a president who has **openly questioned central bank independence**. Trump has made deep rate cuts a condition for the nomination, and Warsh made overtures to meet this requirement last October, declaring, “We can substantially lower rates and make 30-year fixed-rate mortgages affordable.” Yet, the hardest part of monetary policy is adjusting rates based on the data. If inflation surges and the data call for no rate cuts or even hikes, will Warsh dare defy Trump? Trump said in Davos: “It’s surprising how people change once they get that job.” This shows his concern that Warsh will become “disobedient” after taking office. Trump’s attacks on Jerome Powell—including permitting criminal investigations and trying to fire governors—have already proved that if the Fed Chair disappoints him, he’ll never stand idly by. Although the Supreme Court could limit the president's power to fire the Fed Chair, Trump could still make Warsh’s tenure difficult through public attacks and by appointing compliant governors. Warsh has acknowledged the importance of independence, saying: “I read in the newspaper about how harsh politicians are to central banks. Well, grow up. Toughen up. What’s the secret to central bank independence? Achieve your goals and do your job well.” For investors, whether Warsh can hold the line between Trump’s political pressures and the Fed’s data-driven approach will be the biggest tail risk for markets in the coming years. Risk Warning and Disclaimer The market has risks, investments need caution. This article does not constitute personal investment advice and does not take into account individual users’ specific investment goals, financial circumstances or needs. Users should determine whether any opinions, views or conclusions in this article suit their particular situation. Investing based on this information is at your own risk.