A potential financial storm is brewing, and it's all centered around President Trump's latest appointment. The controversial move could have far-reaching consequences for the US and global economies.
Meet Kevin Warsh, Trump's nominee for the next chairman of the US Federal Reserve Board. Warsh has a bold plan: to significantly reduce the Fed's balance sheet. But here's where it gets controversial... this move isn't without its risks, and it could spark a financial crisis.
Warsh believes that a smaller Fed balance sheet will boost economic growth and lower inflation. He argues that the Fed's expansion of its balance sheet, through printing money, has led to inflation without real economic growth. Additionally, he thinks a large balance sheet keeps US rates low, encouraging excessive government spending. However, one might question whether Warsh has considered the US government's massive $38 trillion debt, which continues to grow rapidly.
Warsh's views on quantitative easing (QE) are particularly interesting. He was on the Fed's board during the first round of QE in response to the 2008 financial crisis, but has since become a critic. The Fed's bond-buying program grew its balance sheet from $900 billion to over $4 trillion before the pandemic, which led to an even larger round of QE, pushing the balance sheet to nearly $9 trillion.
In mid-2022, the Fed began quantitative tightening (QT), allowing bonds to mature without reinvesting. This program ended in December 2022, but the Fed continues to buy Treasury bills at a rate of $40 billion per month. This buying, despite the Fed's denials, is a form of QE, highlighting the risks of Warsh's ambition.
QE played a crucial role in saving the US and global financial systems during the 2008 crisis. However, the Fed's persistence with bond-buying long after the crisis had passed is a point of contention. Economies were either in recession or stagnant, with little to no inflation, and central bank interest rates were at or below zero. Some argue that the Fed's original QE program ran too long, but the pandemic forced its hand, leading to an even larger round of bond and mortgage purchases and a massive outbreak of inflation as global supply chains froze.
The Fed's policies, including increased interest rates and QT, have helped bring inflation down from its peak of around 9% to just below 3%. While Trump's tariffs have contributed to inflation remaining above the Fed's target of 2%, their full impact may push rates back up in the coming year.
Warsh's plan to shrink the Fed's balance sheet aims to reduce its influence on the US financial system and economy, allowing the private sector to step in and make more market-driven decisions. However, there are some inflexible components in the Fed's accounts that Warsh cannot easily manipulate.
Among the Fed's liabilities is the US currency in circulation, currently around $2.4 trillion and growing with the economy. There's also the US Treasury account, which fluctuates but is currently around $900 billion. Finally, there are reserves, or deposits from banks held at the Fed, which are the most liquid and highest-quality assets in the financial system, used for interbank payments and managing bank liquidity.
Warsh can't do much about the currency liabilities or the government's account, so there's a core of about $3.3 trillion (and growing) of Fed liabilities that can't be reduced. This leaves the reserves as the primary target of his attention.
These reserves have grown significantly since the 2008 financial crisis, partly due to the Fed paying interest on them to attract more reserves and maintain what it calls "ample" reserves in the system. Post-crisis banking reforms also introduced liquidity regulations, forcing banks to hold more high-quality liquid assets.
Warsh seems to believe that rolling back some of these regulations would release reserves, allowing Wall Street to better fund Main Street at lower interest rates. He wants to move away from the "Fed put" - the belief that the Fed will always intervene to support asset markets - and have markets price in risk.
While the Fed's balance sheet could be made smaller through banking deregulation and allowing more government securities to mature without reinvestment, this could have significant implications for financial stability. It could make the US and global financial systems more volatile and vulnerable to a meltdown.
In 2019, a scary incident occurred within the US system. The cost of short-term borrowing in the repo market, where borrowers provide high-quality collateral like Treasury securities in return for cash, suddenly soared. Interest rates in this market, which generally sit within the Fed's target range (2-2.25% at the time), spiked to 10%, signaling a severe cash shortage similar to the market seizure during the GFC when Lehman Bros and Bear Stearns were failing.
The New York Fed intervened immediately, injecting the equivalent of $110 billion into the market to calm things down. A similar situation developed in December 2022, prompting the Fed to start buying Treasury bills to ensure market liquidity and keep rates within its target range.
This suggests a fine line between the Fed having "ample" reserves to support liquidity and a liquidity crisis. Shrinking the Fed's balance sheet and reducing these reserves transfers liquidity risk management to private banks, even as their regulatory liquidity requirements are reduced.
Warsh believes that the US will experience stronger growth with lower inflation and interest rates due to the productivity boom he expects artificial intelligence to bring. He wants to remove what he sees as the constraints on growth imposed by the Fed's large presence in the financial system and economy.
While Warsh's vision may be appealing, the timing and impact of any productivity boom are uncertain. If he succeeds, he would be upending Fed policies and the structure of the US system, reintroducing risks that the Fed's balance sheet has been designed to mitigate, before the potential benefits of AI-driven productivity become clear.
What do you think? Is Warsh's plan a bold move towards a more stable financial future, or a risky gamble that could lead to disaster? Share your thoughts in the comments below!
