BREAKINGVIEWS-Kevin Warsh can work with the Fed to shrink it

By Gabriel Rubin

WASHINGTON, Feb 25 (Reuters Breakingviews) - After fifteen years of critiquing and cajoling the United States’ central bank, Kevin Warsh is poised to run it. Having outlasted his rivals to win President Donald Trump’s nomination as chair, the 55-year-old has a unique opportunity to reshape the Federal Reserve away from the long shadow of the 2008 financial crisis. Indeed, his priorities run directly counter to that long era: shrinking the Fed’s role in the economy, unfettering lenders, and reassessing the tools used to ward off calamity. His sterner broadsides and shifting stances deserve skepticism. If he stays true to his institutionalist past, though, he really can reorient the bank’s relationship with the rest of government.

A Stanford- and Harvard-trained lawyer who served as a Fed governor from 2006 to 2011, Warsh made his reputation as an extreme hardliner on inflation risks, even after the Great Recession saw U.S. unemployment hit 10%. He left his post in part over his opposition to quantitative easing programs, which then-Chair Ben Bernanke engineered to provide liquidity to a frozen economy. The Fed’s purchases of Treasuries and mortgage-backed securities saw its balance sheet grow from less than $900 billion prior to the crisis — mostly composed of currency in circulation — to a peak of $9 trillion after the COVID-19 pandemic.

Warsh says he will seek to unwind that expansion, particularly when it comes to MBS. That puts him on the same page as Treasury Secretary Scott Bessent, who claims that the bulging balance sheet distorts debt markets. The former Morgan Stanley banker doesn’t want to stop there, though. The Fed’s emergency liquidity tools, financial regulation and forward guidance on monetary policy provided through press conferences and data releases also face the axe.

Many of these changes were born of necessity. The expansion of the balance sheet was a reaction to the inability of ordinary policy to push beyond the bound of zero rates. This growth, in turn, “creates more demand for reserves and other Fed liabilities,” leading to a ratchet effect, per Jonathan Wright, a former staffer at the central bank and professor at Johns Hopkins University. It led to a complete overhaul of the fundamental mechanism through which the Fed sets rates, formerly achieved by controlling the supply of reserves when they were scarce. There are upsides to this post-2008 regime, too: tweaking the availability of reserves “required daily interventions in the markets by the Fed, and these problems were made worse when rates were at or near zero,” board governor Christopher Waller, a Trump appointee, noted in July.

Any change will therefore be incremental, rather than drastic. The Fed can probably roll the $2.3 trillion in MBS off its books, reinvesting the money in shorter-term Treasuries. Aligning with Bessent’s Treasury Department on issuance and purchases of government debt can help to improve market liquidity. With questions about international demand for U.S. assets and the degree to which the yield curve can be controlled running high, further working with the White House to allow banks to deploy more capital into buying Treasuries can bolster demand. After all, as Carl Tannenbaum, chief economist of Northern Trust posed the dilemma of a retrenching central bank: “If the Fed isn't a big buyer, who is going to absorb it?” Bessent admits the need to go slow, saying the Fed probably won’t make any significant balance sheet moves before 2027.

Such tight coordination with political officials is, of course, a taboo subject. The Trump administration, in its quest for more accommodative policy, continues to run a pressure campaign against current officials. The Justice Department has not dropped its criminal probe of Chair Jerome Powell, ostensibly over the costs of renovating the bank’s headquarters. The White House still wants to fire Governor Lisa Cook, in a case awaiting resolution by the Supreme Court.

Former Chairs Bernanke and Janet Yellen have warned repeatedly about the dangers of allowing the executive branch to dictate interest rates, plainly visible in countries like Turkey. Warsh – who has taken a notably more dovish turn under this administration – will need to establish his independent bona fides. He has a security blanket: thanks to presidential term limits, he will not need to worry about winning Trump’s renomination in the future. Proving intellectual consistency once he’s in place is paramount. After all, interest rate decisions are made by a majority of the 11 Federal Open Market Committee members. They will need convincing.

A principled defense of monetary policy independence could help rally other members for significant changes, especially where support already exists on Wall Street and on the board. The Fed’s vice chair for banking supervision, Michelle Bowman, has already begun to pare supervisory staff by 30%. Looser bank capital rules—including a revised Basel III Endgame proposal—will please big banks, and Republicans in Congress.

The most important test of any push to end “mission creep,” though, can only come in a crisis. The Fed has created tools and been granted authorities by Congress that did not exist when he was first appointed to the board all the way back in 2006. Its liquidity tools as the lender of last resort were forged amid complete meltdowns, including one in which Warsh himself played a starring role. He is credited by Bernanke and others for serving as a conduit to Wall Street during the darkest days of the Great Financial Crisis, including facilitating JPMorgan Chase’s 2008 takeover of Bear Stearns. Artificial intelligence could prove enormously disruptive, especially if the vast investment supporting it falters. Labor markets have slowed. A trade war rages.

If anything truly goes awry, the Fed can, and must, take risks that no other institution can. While bailouts and cushioned consequences for risky behavior do not make for good economics, they can also prevent a credit crunch from becoming a full-blown depression. Warsh, in an hour of extreme need, may find that there are no atheists in foxholes, and humble himself before the might of an omnipotent Fed.

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