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May 22, 2026 | 13:08
Warsh Aweigh
Economics
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Fixed Income Strategy
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Warsh AweighKevin Warsh has taken the captain’s wheel of the Fed, looking to take a different tack. Now to convince the crew. |
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On May 22, Kevin Warsh was sworn in as the 17th Chair of the Federal Reserve Board of Governors, filling the seat vacated by Stephen Miran. Jay Powell, whose term (as Chair) ended on May 15, served as ‘chair pro tempore’ in the interim. Warsh’s first FOMC meeting (as Chair) will be June 16-17, and the market is speculating about that first confab, let alone subsequent meetings. Stoking the speculation are: (1) last meeting’s more hawkish-leaning dissents; (2) Powell’s announcement that he’s staying on for a little longer; (3) the tone of subsequent data (emphasized by faster-than-expected core CPI/PPI inflation readings and stronger-than-expected growth in payrolls and core retail sales); and, (4) Warsh’s reported preference for lower policy rates and his “regime change” agenda. Committee’s welcome giftsThe FOMC kept rates unchanged last month as expected, with the target range for fed funds at 3.50%-to-3.75%. This was the third straight pause after three consecutive 25 bp cuts. Governor Miran dissented for the sixth straight time (covering his entire tenure) in favour of a rate cut (or a larger one). The market is questioning whether Warsh will follow Miran’s dovish wing prints. At this point, we do not think so (at least not at Warsh’s first confab as Fed head), given the Chair’s traditional role in crafting and communicating the Committee’s consensus. The Fed also kept its forward guidance unchanged with the phrase: “In considering the extent and timing of additional adjustments to the target range for the federal funds rate…” Toggling in and out the “the extent and timing of” modification, this is the language used since rate cuts began in September 2024. Whenever the modification has been absent, it has signalled a cut next meeting (Sept./Nov. 2024; Sept./Oct. 2025). Otherwise, it has signalled a cut as early as next meeting or after a pause. Warsh’s first of two welcome gifts is that this ‘easing bias’ has become problematic for some FOMC participants. Three voters favoured altering the language and dissented accordingly. Cleveland President Hammack, Minneapolis’ Kashkari, and Dallas’ Logan supported the pause “but did not support inclusion of an easing bias in the statement at this time.” Given the increased risk of faster inflation from the oil shock (with the labour market stabilizing in the background), they preferred a more neutral statement to convey that rate cuts were no more likely than rate hikes. The meeting’s Minutes revealed that “many” participants (not just the three voters) wanted to remove the easing bias. More profoundly, “a majority of participants highlighted, however, that some policy firming would likely become appropriate if inflation were to continue to run persistently above 2 percent.” There are still 25 days to go, but if the tone of recent data persists, we reckon the ranks of the ‘neutralists’ will be increasing in June. There is the chance that at least four more voters (among the remaining nine) will join April’s trio and the easing bias could be dropped. The market is questioning whether Warsh will be onside should the majority favour shifting policy further away from potential easing, at least for a little while, and more towards possible tightening. The second welcome gift is that former chair Jay Powell will be staying on the Board of Governors for a while longer. Typically, ex-Chairs depart the Board regardless of how long is left in their term as Governor (until January 2028 in Powell’s case). Powell said he “will not leave the Board until this investigation [by the Justice Department into his congressional testimony on the Fed’s HQ renovation costs] is well and truly over, with transparency and finality.” Plus, Powell probably wants to also be around for the Supreme Court’s ruling on the President’s ability to fire Governor Lisa Cook. He said he would be keeping a “low profile”. Regime changeIn his Senate hearing, Warsh said he would push for “regime change in the conduct of policy.” Calling the inflation flareup during 2021 and 2022 and its subsequent failure to return to target a “fatal policy error”, Warsh wants to change several aspects of the Fed’s policy formation and communication practices. However, wanting and effecting change are not the same. Some changes will require congressional action while others will require majorities on the Board of Governors or in the FOMC. Below, we briefly survey some of the items on Warsh’s regime change ‘wish list’ (in no order). There is no guarantee that he will be able to muster sufficient support for any one of them, let alone tick them off expeditiously. Any regime change at the Fed is bound to be more of an evolutionary process than a revolutionary one. |
Shrinking the balance sheet: The Fed’s total assets are currently $6.71 trillion (as of May 20). Thanks to quantitative tightening (QT), this is down $2.25 trillion from the record high tucked under $9 trillion in April 2022 (Chart 1). However, this is up $178 billion from December’s low when QT ended and incremental reserve management purchases (RMPs) of Treasury bills began. For those who argue the balance sheet is too big, the fact that it is growing again, even incrementally, must be disturbing. As a Fed governor from February 2006 to March 2011, Kevin Warsh was very critical of quantitative easing (QE). Indeed, it is reported that the disagreement over QE was a reason Warsh left the Fed. According to the Wall Street Journal (and Greg Ip), Warsh “blames Fed bond-buying for encouraging the federal government to run steep deficits, suppressing market signals and ultimately unleashing inflation [1].” |
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To understand why total assets (mostly Treasury securities and MBS) are so large, one must look at the liabilities side of the ledger, specifically reserves. In the wake of Global Financial Crisis (GFC) and three rounds of QE, reserves peaked above $2.8 trillion during 2014 and 2015. In the year before the GFC prompted an alphabet soup of credit and liquidity support measures (along with QE), reserves averaged under $10 billion. The working assumption was that the eventual normalization of the balance sheet (via QT which started in late 2017) would result in massively lower reserves, but still above pre-GFC norms because interest was now being paid on them (unlike before). But a funny thing happened on the way to normalization. New liquidity regulations started being phased in during 2015 (through 2019). Banks were required to hold significantly more liquid assets, among which reserves were an option. Reflecting the consequent enormous increase in the demand for reserves, in 2019, the Fed formally shifted to an ‘ample reserves’ regime. |
Governor Powell and other Fed officials often refer to reserves as a share of GDP, to shed light on demand. At the height of 2019’s liquidity crisis [2], reserves (and reverse repos with money market funds) dropped to 6.8% of GDP in Q3 (Chart 2). This was obviously too low. In an often-cited speech by Governor Waller on “Demystifying the Federal Reserve’s Balance Sheet” in July 2025, he argued that in 2019, liquidity pressures began to emerge when the reserves-to-GDP ratio slipped below 8% and assumes that “9 percent is the threshold below which reserves would not be ample.” That translates to $2.87 trillion based on 2026 Q1 GDP. The actual figure averaged $2.98 trillion amid the resumption of T-bill purchases for reserve management purposes. To meaningfully reduce the size of the Fed’s balance sheet will require regulatory changes that significantly reduce banks’ demand for reserves. For the record, efforts at regulatory reform are occurring. Changing the inflation targeting regime: For the PCE price index, Warsh argues that the trimmed mean and median measures are better indicators of the underlying inflation trend than the core (excluding food and energy) metric. In his hearing, he said: “The measures I prefer are looking at things that are called trimmed averages… We take out all of the tail-risks, all of the one-off items, and we ask ourselves whether the generalized change in prices is having second-order effects on the economy.” Indeed, other central banks such as the Reserve Bank of Australia and the Bank of Canada employ trimmed means among their operational inflation targets. |
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Currently, both measures are running slower than the core inflation rate of 3.2% y/y in March (Chart 3). The trimmed mean is 2.4% y/y and the median is 2.8% y/y, suggesting the underlying trend is not as sticky as depicted by the core metric. Note that during the run-up in inflation during 2021 and 2022, both measures ran consistently slower than the core beginning in March 2021 and lasting until February 2023 for the trimmed mean and May 2022 for the median. Would this have made the Fed less likely to act earlier and avoid the “fatal policy error”? Note also that the CPI version of the trimmed mean and median measures ran at 2.7% y/y and 2.8% y/y rates, respectively, in April—much closer to 2.8% y/y core CPI inflation. Finally, Warsh favours a range for the inflation target over the current 2.0% (point) target. Of course, it is the FOMC who decides on how to interpret the price stability mandate from Congress. |
Changing forward guidance: In his Senate hearing, Warsh said: “Unlike many of my colleagues past and present, I don’t believe in forward guidance… I don’t believe that I should be previewing for you what a future decision might be.” He argued that forward guidance can be a “straitjacket” and “the Fed must preserve its ability to pivot when circumstances demand.” Like Warsh, other Fed officials are also not fans of the ‘dot plot’ because the market and media do not appear to fully appreciate the fleeting nature of the dots. They are ‘point-in-time’ projections of the appropriate path for monetary policy given specific economic outlooks that are sensitive to new data and events. However, it does not appear that the dot plot is a “straitjacket” in any way for the Fed. In practice, policy rates rarely follow the path portrayed by the median dots (Chart 4). |
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From a communications perspective more broadly, Warsh argues that among the Chair, Governors, district Presidents, and other officials, Fed communication has become excessive. In his hearing, Warsh said: “I think truth‑seeking is more important than repetition… If one has a press conference, one wants to deliver some important news.” There is a chance Warsh could personally opt for fewer pressers, but the void would quickly be filled by other officials. Again, it is the FOMC who decides on communications strategy. Note that it already puts restrictions on what officials can say around the timing of Committee meetings (blackout period). Ultimately, monetary policy is a democracy. It takes a minimum of 7 of 12 voting members in the FOMC to change existing policy. Kevin Warsh has one vote, but in his role as Chair of the Board and of the FOMC (the latter will be voted on at the first confab), he has a platform on which to build moral authority. Promoting rapid and radical change to existing policy and communication practices is not the way to inspire other Board members and FOMC participants to follow him and craft consensus. Given his experience, we reckon Warsh is aware. |
[1] Critics of the balance sheet’s size may seize upon the fact that core PCE inflation peaked at four-decade highs around the time the Fed’s balance was peaking, with total assets roughly doubling from their pre-COVID level. However, tempering a causality conclusion is the fact that the Fed struggled for more than a dozen years to push core inflation up to 2% and keep it there while total assets roughly quintupled from their level before the Global Financial Crisis (GFC). [^][2] As QT continued as 2019 unfolded (reducing the supply of reserves), the Fed was not sure where the new increased demand for reserves stood. They found out the hard way, via spiking overnight interest rates during the late summer, as banks were increasingly reluctant to lend out their now ‘scarce’ reserves. QT ended early and T-bill purchases for reserve management purposes began. This continued until the pandemic shifted the reserves building gear into hyperdrive. [^] |