Trump Expects His Fed Chair Nominee to Cut Interest Rates. Here’s How Kevin Warsh Might Try to Do It
TLDR:
- Kevin Warsh, Trump’s Fed chair nominee, faces Senate confirmation hearing Tuesday
- Warsh plans to cut rates by shrinking the Fed’s $6.6 trillion balance sheet
- Shrinking balance sheet by $1 trillion = equivalent of 50 basis point rate hike
- Fed holds $1.6 trillion in Treasurys and $1.9 trillion in mortgage-backed securities
- Market skeptical of whether this argument will convince Fed policymakers
Warsh’s Balance Sheet Strategy
When President Donald Trump selected Kevin Warsh to be the next head of the Federal Reserve, the conventional wisdom was that Warsh must have somehow convinced the president that he would be able to persuade his fellow central bankers to lower interest rates. But how?
It’s been clear for months that there’s not much support for lowering rates among the 19 top Fed policymakers. Stephen Miran, the Fed governor with the closest ties to the Trump White House, has been a lonely voice calling for deep rate cuts.
But there is one way Warsh might be planning to get Fed officials to go along with monetary-policy easing, according to economists: by shrinking the Fed’s balance sheet.
Warsh’s previous speeches suggest he believes that shrinking the balance sheet by $1 trillion has an effect on the economy equivalent to an interest-rate hike of 50 basis points. Warsh will press his Fed colleagues to cut short-term rates to offset such a tightening of the balance sheet, said Joe Gagnon, a fellow at the Peterson Institute for International Economics.
Essentially, Warsh would be tightening policy with one hand while easing with the other. But it would get interest rates down. “Shrinking the balance sheet may indeed be an argument Warsh leans into as to why rates should be lower,” said Mark Cabana, head of U.S. rates strategy at BofA Global Research.
Warsh Under Pressure to Lower Rates
In January, Trump picked Warsh over four other candidates to replace outgoing Fed Chair Jerome Powell. Warsh served as a Fed governor from 2006 until 2011 and has been a consistent critic of the central bank’s policies ever since.
During his first term as president, Trump considered Warsh for Fed chair but passed him over in favor of Powell, a decision the president has often said he regrets. Powell’s term as chair ends in May.
Significant roadblocks to Warsh’s Senate confirmation remain, but whenever he does finally take the reins at the Fed, he will be under tremendous pressure from the White House to bring interest rates down.
Earlier this week, Trump repeated his assertion that interest rates should be much lower than the current range of 3.5% to 3.75%. Asked during an interview on Fox Business Network if he thought rates would go lower later this year, Trump replied: “When Kevin gets in, I do.”
The president has joked that he would sue Warsh if the Fed didn’t cut rates sharply. But many Fed officials have said they’re wary of cutting rates until there’s progress on bringing inflation closer to the central bank’s 2% target. The war in Iran has boosted inflation to the highest level in two years, making officials even more cautious.
What Is the Fed’s Balance Sheet?
Ben Bernanke pioneered the use of the balance sheet in 2008, during his term as Fed chair. In the midst of the financial crisis, the Fed had lowered rates to zero, but it still wasn’t enough to stimulate the economy. So the central bank bought long-term Treasurys and mortgage-backed securities to help get interest rates down and spark a recovery.
These assets were matched by liabilities — reserves held by banks in accounts at the Fed. The Fed pays the banks interest on these reserves.
The Fed has tried to shrink its balance sheet two times in recent years. The first effort ended with a market meltdown in 2019, with rates spiking in money markets. The second effort started in 2022 and ended more calmly last December, but with the balance sheet at $6.6 trillion, higher even than at the 2017 peak.
Two Choices for Shrinking the Balance Sheet
The Fed has two choices for shrinking its balance sheet, Cabana at BofA Global Research said. First, it could announce the sale of assets on the open market. It’s highly doubtful this will happen, he said.
“Selling assets would be extremely disruptive to financial markets. It would tighten financial conditions and result in notably lower risk-asset values,” he said. Although a slower economy would potentially justify lower rates, the cost would be high. “I don’t think Trump would sign up for that at all,” Cabana said.
The more plausible option would be that the Fed would focus on the liability side of its balance sheet — the $3 trillion in reserves that banks hold at the Fed. Banks keep reserves in part to meet liquidity standards that were put in place after the 2008 financial crisis.
Our Take
Kevin Warsh’s balance sheet strategy is clever in theory but faces significant practical challenges. The idea of tightening with one hand while easing with another could theoretically get rates down, but convincing a skeptical FOMC to buy this argument is another matter entirely.
The real bottleneck is bank reserves. Post-2008 regulations have created a system where banks need to hold large amounts of reserves for liquidity purposes. Reforming these regulations would take years, and Trump — who wants rate cuts before the midterm elections — doesn’t have that kind of patience.
The market reaction will be telling. If Warsh pushes this narrative and rates don’t fall as expected, the credibility of the Fed itself could be questioned. The balance sheet is a blunt instrument, and using it as a rationale for rate cuts could backfire if inflation remains elevated.
For now, the most likely scenario is political pressure trumping monetary policy logic. Whether that ends well for markets is anyone’s guess.
