A changing Federal Reserve

Kevin Walsh's Confirmation Hearing Strategy

• Walsh's primary objective was Senate confirmation, not signaling market direction or persuading FOMC colleagues.
• He avoided making a direct case for rate cuts, instead hinting at them only indirectly.
• Walsh emphasized a significant productivity boom from AI but stated the Fed "cannot bank on it."
• He characterized the labor market as being at "full employment" while noting inflation has not yet fully returned to target.
• The consensus takeaway is that Walsh made a stronger case for holding rates steady for an extended period than for cutting them.

Inflation Targeting and Structural Shifts

• Walsh expressed a preference for median or trimmed mean inflation metrics over core PCE, arguing core arbitrarily omits food and energy.
• A potential structural risk involves "cherry-picking" metrics if trimmed mean (2.3%) and median (2.8%) run below core PCE (3%).
• The FOMC is likely to reject an official shift to trimmed mean/median, preferring to keep them as supplementary measures rather than the primary target.

Federal Reserve Communication Changes

• Walsh plans to adopt a policy of holding quarterly press conferences only when new information is available, moving away from monthly frequency.
• He intends to unilaterally eliminate the Summary of Economic Projections (SEP) to reduce perceived constraints on policy nimbleness.
• Removing the SEP risks increasing internal dissent and reducing the committee's ability to express disagreement quietly.

Jay Powell's Final Press Conference Outlook

• The upcoming session is expected to be Powell's final press conference as Fed Chair.
• Powell is projected to sound hawkish due to persistent upside inflation risks linked to the Iran conflict and stable-to-improving labor data.
• The Fed aims to keep market pricing on a "flat path" for the rest of the year rather than providing directional guidance during high uncertainty.
• Key scrutiny points include Powell's openness to rate hikes and whether he will shift forward guidance language to reflect two-sided risks.
• Divergence among members is notable; Doves Mary Daly and Christopher Waller have signaled the war may impact inflation more than growth.

Base Case for Federal Funds Rate

• The Bank of America baseline scenario anticipates two rate cuts, scheduled for September and October.
• This view relies on softer labor data emerging in the summer and headline inflation peaking in the current month.
• The forecast assumes tariff-related year-over-year effects will roll off by September.
• Conviction is low; the analysts note it is a "very close call" whether the Fed cuts rates at all this year.

US Dollar Outlook and Risks

• Kevin Walsh's appointment is viewed as a bearish factor for the dollar, assuming he will push for cuts once confirmed.
• The market has priced in a prolonged pause; any deviation toward hikes would be a higher barrier than a deviation toward cuts.
• Near-term dollar movement is driven by "headline noise" regarding war peace talks, resulting in a tight trading range.
• Medium-term support is expected from US insulation against terms-of-trade shocks and potential oil supply constraints.

Kevin Walsh's Balance Sheet Policy

• Walsh intends to reduce the total size of the balance sheet and shift composition away from long-duration securities.
• Reducing the balance sheet size is constrained by the "ample reserve" regime; shrinking it further requires reducing liabilities (currency, Treasury cash, or reserves).
• Reducing reserves is the only viable path, likely achieved through bank-friendly adjustments to liquidity regulations (HQLA definition).
• Expected reserve reduction is estimated at $200–$500 billion (approx. 10% of demand), insufficient for a major balance sheet contraction.

Balance Sheet Composition and Reinvestment

• The most feasible method to shorten duration is altering the reinvestment process of maturing treasuries rather than active asset sales.
• Instead of proportionally reinvesting across maturities, the Fed would reinvest maturing funds exclusively into short-term (e.g., 3-year) securities.
• Simulations suggest this could reduce the Fed's weighted average maturity from 9 years to 3 years within four years.
• The US Treasury is expected not to offset this shift, resulting in a net market impact of zero.

Linking Balance Sheet to Rate Cuts

• Walsh has proposed linking balance sheet reduction to the ability to cut rates, a view held by Governor Myron but disputed by the strategists.
• The analysts argue that reducing duration risk without a market impact does not provide a compelling economic justification for rate cuts.
• Walsh is expected to make the argument for linking the two, but it is unlikely to convince his FOMC colleagues or the market.