How Warsh Could Shape Fed Policy

Confirmation Status and Timeline

• The Justice Department dropped its investigation of current Fed Chair Jerome Powell on Friday, clearing a significant political hurdle.
• Senator Tillis has reiterated that Kevin Warsh is expected to be confirmed as Fed Chair shortly.
• Warsh is projected to attend his first FOMC meeting in June.
• President Trump's administration previously extended the terms of existing governors by five years in December, preventing the immediate replacement of the board.

Warsh's Monetary Policy Framework

• Warsh is historically characterized as a "lieutenant" to Ben Bernanke who prioritizes strict criteria for using the balance sheet.
• In 2011, Warsh voted for quantitative easing (QE) but publicly criticized it as a mistake, establishing his view that QE should be an emergency tool with a high threshold for use.
• Warsh advocates for reducing the Fed's communication burden, arguing the central bank has relied too heavily on forward guidance and that the dot plot "boxes in" members.
• He is expected to either eliminate or downgrade the dot plot to encourage Fed presidents to speak less.
• Warsh anticipates AI adoption and Chinese manufacturing overcapacity to be disinflationary over the long horizon, though he acknowledges current war-related inflationary pressures make this argument difficult to advance immediately.

Policy Implications and Rate Outlook

• Warsh intends to manage the balance sheet more closely with Treasury Secretary Bessent, though both are likely to avoid abrupt reductions that could spike rates.
• The market currently prices in a near-zero probability of rate cuts in 2026, with the first cut pushed to 2027 due to sticky inflation and the "scarring" from past forecasting errors.
• Warsh's preference to "look through" productivity gains (similar to Greenspan in the 90s) may clash with the FOMC's current risk-management mandate requiring visible evidence of inflation nearing the target before cutting.
• Rob Kaplan advises Warsh to approach the role with a "clean sheet," cautioning against rigid reliance on the Dallas Trim Mean due to its potential lag during oil price shocks where spikes bleed into broader price indices.
• Kaplan suggests the real Fed funds rate is currently neutral at 0.75% to 1.0%, meaning the war has effectively pushed neutral rates higher.
• Despite potential dovish leanings on long-term disinflation, Warsh must secure seven votes to pass any policy, necessitating a consensus-building approach rather than a dissenting one.

Market and Economic Forecast

• Goldman Sachs has adjusted its GDP forecast for the second half of 2026 downward to approximately 2.1% (from 2.5%) due to oil price shocks and geopolitical instability.
• The probability of central bank rate cuts has been pushed out significantly as inflation proves stickier than anticipated.
• The 10-year Treasury yield is currently above 4.30%, acting as a constraint on rapid balance sheet reduction.
• Regulatory reforms, such as changes to supplementary leverage ratios, may allow banks to hold fewer reserves, theoretically enabling a smaller balance sheet.
• Kaplan emphasizes that the Fed is currently operating "in the fog," acting as a spectator to Middle East events (specifically the Strait of Hormuz) until the conflict de-escalates.

Fed Independence and Political Context

• While the confirmation process was unusually politicized, Kaplan views the current trajectory as more conventional, noting that the administration failed to replace the president of the Federal Reserve Bank of New York or other bank presidents as feared in the fall.
• Kaplan argues that while the Fed is less independent regarding regulatory reform over the last two decades, Warsh's need to build consensus with a diverse group of governors and presidents will preserve operational independence.
• The administration's attempt to influence the Fed by seeking early removals of Powell and Cook did not materialize, and the board remains intact.