Pressured Before Taking Office? Trump Sends Kevin Warsh Strong Signal on Rate Cuts

TradingKey - U.S. President Donald Trump stated clearly in a media interview on Wednesday that if his nominee for Federal Reserve Chair, Kevin Warsh, expresses a bias toward raising interest rates, he will not get the job.

Trump pointed out that current U.S. interest rate levels are "ridiculously high," emphasizing that "there is no doubt that rates need to be cut." Trump stated that the U.S. is now a "wealthy country" with constant capital inflows and rapid economic growth, making interest rate cuts both reasonable and necessary in this context.

He emphasized that it was under his leadership that the U.S. economy achieved a strong rebound, and that the debt issue would become less prominent in the face of growth.

Regarding his understanding of Warsh's policy stance, Trump said he believes Warsh "gets" his intention to cut rates, and that Warsh has supported similar views all along.

Warsh has criticized the Federal Reserve multiple times in recent years for keeping rates too high and for repeated errors in judgment, an attitude that aligns perfectly with the White House's current policy expectations.

However, while Warsh caters to Trump's views on interest rates, his advocacy regarding deeper monetary policy tools may diverge from the White House's stance. Warsh favors achieving accommodative policy by shrinking the Fed's balance sheet, a path not entirely consistent with Trump's preference for expansionary fiscal policy, signaling potential contradictions.

Internal and External Constraints on Balance Sheet Strategy

Kevin Warsh believes that the Fed's long-term use of large-scale quantitative easing (QE) to suppress long-term rates has not only distorted market prices but also implicitly supported excessive government spending, weakening fiscal discipline. The net effect has been to make the yield curve higher and flatter, exacerbating market distortions.

Warsh advocates for a gradual reduction in the size of the balance sheet to restore the "purity" of monetary policy, allowing interest rates to be formed under more authentic market conditions. However, the reality is far more complex than the theory, as this strategy faces multiple operational constraints.

On one hand, historical experience shows that any previous attempt by the Fed to shrink its balance sheet has been accompanied by a strong market reaction.

For instance, the mere hint of reduced asset purchases in 2013 triggered the well-known "Taper Tantrum," causing significant volatility in global markets. Rapid balance sheet contraction tends to drive up long-term interest rates, thereby tightening financial conditions and directly conflicting with rate-cut objectives.

On the other hand, the current financial system is highly dependent on liquidity.

As Joe Abate, interest rate strategist at SMBC Capital Markets, pointed out: "Warsh may want to reduce the Fed's footprint in the market, but large-scale balance sheet reduction is not feasible."

He emphasized that when reserve balances in the banking system fall below approximately $3 trillion, short-term interest rates tend to experience sharp volatility, undermining the Fed's ability to control its rate targets. This effectively constitutes a floor for balance sheet contraction.

Furthermore, shrinking the balance sheet is not only a technical issue but also a challenge of political and organizational coordination. Several Fed officials currently view the balance sheet as a standard policy tool and may be cautious or even opposed to active contraction in the absence of clear market risks. Consequently, even if Warsh maintains a firm stance, he would still need to rely on collective support within the Federal Open Market Committee (FOMC) to implement the policy.

To address this dilemma, analysts believe the Fed could "pave the way" for balance sheet reduction through structural means.

For example, reducing the compliance burden on banks regarding liquidity management and increasing the appeal of the discount window and standing repo facilities could make banks more willing to use the central bank's short-term liquidity tools, reducing reliance on excess reserves. This would help release liquidity and provide operational room for a modest contraction of the balance sheet without disrupting financial markets.

David Beckworth, a senior research fellow at the Mercatus Center at George Mason University, also noted that Warsh could use the Fed's existing policy review framework to reassess the strategic positioning of the balance sheet. He suggested that the Fed could also consider deeper coordination with the Treasury, such as policy cooperation through bond swaps. He emphasized:

"The Fed is like a large ship that turns slowly, which might be a good thing, as overly abrupt adjustments could shock the financial system."