Understanding Kevin Warsh's Plan for the Fed

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1:02Bloomberg Audio Studios. Podcasts, radio, news. I'll tell you, if our new head of the Fed, who I think is going to be great, if he does the job that he's capable, we can grow at 15%. I think more than that.

1:27I'm Stephanie Flanders, head of government and economics at Bloomberg, and this is Trumponomics, the podcast that looks at the economic world of Donald Trump, how he's already shaped the global economy and what on earth is going to happen next. This week, we look at what some would say was the single most important personnel decision that Donald Trump has made in the last year, choosing Kevin Walsh to be the next chairman of the Federal Reserve. Assuming Walsh is confirmed, that's one piece of Trumponomics we can expect to be shaping the American and global economy for some time after the president himself has gone.

2:03So how will Mr Walsh lead the world's most important central bank? And with relations between the Fed and the White House quite so fraught, will he be able to win the internal support he needs to be effective, given the intensely political build-up to his appointment? For what it's worth, the market moves in the days when the choice of Kevin Walsh was confirmed in mid-January, suggest investors think he won't let policy be dictated by the President and won't let inflation run amok. You can see that in the rise in the dollar and most strikingly in the dramatic fall in the price of gold and silver.

2:39And yet there are big areas of uncertainty about what Walsh really thinks about monetary policy and interest rates and about his plans for the Fed itself, which he's been pretty critical of in the past. When I was thinking about the people who could both understand this story and explain how markets were thinking about it, my friend Krishna Guha was the first name that came to mind. Krishna is the vice chairman and head of economics and central bank strategy at the investment research group Evercore ISI. Before Evercore, he was an executive vice president at the New York Fed. And we also overlapped briefly at the Financial Times many years ago, where Krishna was a senior writer on global economics and economic policy.

3:21firstly i guess we had that quite dramatic market reaction to his appointment seemingly investors drawing some quite clear conclusions about what he was going to mean for the fed and not mean for the fed how did you interpret the reaction and what were some of the key takeaways for you so we thought going in that the market would initially trade wash hawkish so rates higher yield curve steeper because of his balance sheet views and concerns that he might restart QT to shrink the Fed's balance sheet, risk off in stocks, and dollar higher, as he would be seen as more of a strong dollar candidate.

4:00So the market reactions that we've seen, which have broadly gone in those directions, I don't think are surprising. At the same time, though, my own view is that the market reaction also reflects a sense that people don't really understand exactly what kind of central bank governor Walsh is going to be. I think that's reasonable. My own views are that Kevin Walsh is unlikely to be an ideological hawk and is more likely to be, in many respects, quite pragmatic. Yes. So let's talk about the monetary policy kind of interest rate piece first, and then we'll get into the balance sheet things, which for some people will be less familiar territory.

4:42The reason I guess that there is a bit of uncertainty about him is on this point, is that he had previously been a hawk. And in fact, as our own chief US economist pointed out, if you look at his record, he was at the Fed 2006-2011. He was more concerned about inflation for longer than most governors. So if you look at the sort of minutes, he was more worried about inflation than downside risks as late as April 2009. So right through 2008 and April 2009, and only really eased up on worrying about inflation August 2009. So it's quite striking to hear him now, since he's been in the running to be Trump's pick for Fed chair, emphasising a rather different approach, a seemingly rather different approach.

5:27But he's pinning it on the impact of AI on productivity on the economy. And that's what he can say has changed since 2009. I mean, do you take that at face value? So I think it is true that Kevin Walsh has, for most of his career, has channeled and represented what one might think of as small C conservative, Republican leaning economic thinking and principles that has generally been more concerned with inflation than the labor market, let's say, more focused on supply side issues than demand side management. And so I think there is an aspect that is channeling a set of thinking on one side, if you like, of the political and economic debates.

6:11But I think what Kevin would say if he was on this call is that there is a consistency in the way that he thinks about inflation risk. So first of all, Kevin is someone who, as I mentioned, thinks that a lot of Fed-type thinking, a lot of New Keynesian-type thinking and the modeling that's come from that puts a lot too much weight on the demand side of the economy and unemployment as a predictor and driver of inflation. Kevin's view is that when the economy strengthens or indeed weakens, the first question you should be asking is whether it's supply-driven or demand-driven. And then, of course, the implications for the economy are potentially very different, as are the implications for rates in those two cases.

6:56I think it's also the case that Kevin believes that the really big inflation risks come when you have a combination of fiscal expansion on the part of the government and money financing on the part of the central bank. Now, of course, the Fed would argue that it hasn't been doing that. But Kevin would say the government issues bonds to finance fiscal stimulus on Monday and the Fed buys bonds in the market on Thursday, it's coming fairly close to money financing that fiscal expansion. So with respect to the GFC, in all kind of my own view at the time, as now, was that Kevin was simply wrong in his assessment.

7:31But if we think of, say, the difference between where we are now and the early phase of the pandemic inflation, right, Kevin would have said, what did we have then? We had an impaired supply side, we had a lot of fiscal stimulus, and we had a central bank that was money financing and expanding its balance sheet. That in Kevin's world is a recipe for high inflation. What do we have today? We have a positive supply shock. We have a large government deficit that Kevin certainly thinks in the long run is not likely to be sustainable at these levels, but it's not going up or down because the tariff take is roughly the same as the one big beautiful bill fiscal giveaways.

8:07And there's no central bank money financing or balance sheet expansion. So Kevin would say the inflation risks today are completely different from the inflation risks that were there in the early phase of the pandemic, which is why I was a hawk then and I'm a dove now. And obviously, there's a lot of uncertainty about what the impact of AI is going to be on the economy. And there are many people who can look at where inflation is now in the US and the sort of possibility that you will actually have a fair amount of stimulus coming down the track as a result of the big, beautiful bill and other things.

8:40So I guess the jury is out on what happens to inflation over the next year or two, whether it makes sense to continue cutting rates or even cut them faster after Kevin Walsh, assuming he becomes Fed chair. But you know him pretty well. How much is he going to be data driven? How much is he going to be willing to sort of change his mind in the face of the evidence or not? Yeah, Kevin's ideal central bank governor is someone who would be 50 % Alan Greenspan, 50 % Stan Drucker-Miller. Why Greenspan? Because Greenspan was, of course, the man who knew he was the one who would look in the fine detail of the obscure economic statistics and private sector data and discern what was really happening in the economy that would show up in the official data many months in the future.

9:28And then, of course, Drucker-Miller being, by many counts, one of the greatest macro hedge fund managers and somebody who had the ability to see in markets the signals about not just where the economy is today, but where the economy would be going in the future. So what Kevin will aspire to do is to have a more forward-looking and richer, more nuanced sense of the outlook for the economy and the balance of risks than you would get by simply plugging last month's employment report or CPI data into a model like FRB US at the Fed. So he's quite scornful of some of those models and the sort of culture of what he would say is backward-looking data dependency.

10:10So I think he will try to be, yes, informed by data, but putting more weight on some of the sort of micro-corporate-level data on the one hand and market signals as data on the other relative to, if you like, the top-tier economic releases. What I would say with respect to that approach is that I have a lot of sympathy with the idea that we really should aim to do better than simply use last month's data to understand where the economy is going. We do aspire to have a rich understanding of private sector data market signals, but it's very hard to be Alan Greenspan, and it's very hard to be Stan Drucker-Miller.

10:51And being a not very good version of those two could be quite dangerous. So it's going to be a challenge to be able to do this in a way that is very sophisticated and successful. And an additional challenge in making policy in a systematic and predictable way when you are, for good reasons, trying to draw in more private sector insight and more market insight, as well as standard macro data. Yeah, I guess this gets a little bit how we think he's going to get on with people at the Fed, but I guess the people who would be concerned about that combination that you talked about. And to your point, he doesn't have the background of Alan Greenspan.

11:33It's easy to be snobby about non-economist Fed chairs. Jay Powell, not done so badly. He's a non-economist. Christine Lagarde was also a lawyer like Kevin Walsh. So it doesn't seem to be, unfortunately for us economists, it doesn't seem to necessarily be a bar to being a good Fed chair central bank governor. But when you're pinning a lot on this argument about how a technological change is affecting the real economy, is that going to give him some persuading to do at the Fed, making that case, trying to get people on side with that, when actually he's been a bit rude about some of the people inside the Fed?

12:11And he's even talked about the need for regime change and breaking some heads and all these kind of phrases? Yeah, so certainly as a bit of a repair job to do in terms of his internal relationships at the Fed, which will be important for his success. And, you know, I think if he's smart, which I know he is, and if he has enough slack from the administration, which I'm not so sure about, he will dial down on the MAGA regime change stuff from here on in. Because of course, even if you're approaching this from the perspective of trying to deliver the several rate cuts that the administration is hoping for this year, your ability to do that is much greater if you are able to win over the, if you like, the old FOMC, get them on side rather than fight trench warfare of the committee through the balance of this year.

13:04Kevin is somebody who has said a lot of rude things about the Fed recently. He's also someone who has very high EQ and good people management skills. And so I could imagine him behind closed doors actually being relatively conciliatory and trying to build bridges with folks. But of course, if he comes in and says that he's going to fire a third of the staff, for instance, as Mickey Bowman is doing on the banking side and has no interest in traditional analytics around Furbis and so forth, that would pit people's backs up and make it less likely that they would follow him. Your point is on the actual merits of the economic judgment.

13:39I don't think people in the Fed are going to be willing to go with a positive productivity shock story just on a assertion or on a belief or an expectation that this is coming. At the same time, I think we are already starting to see certain things in the data that are starting to point in that direction. The Fed upgraded its productivity assessment for this year in December, when Powell essentially agree, acknowledge that the base productivity growth has already stepped up in the US. My own analysis suggests that productivity this year, next year will be, again, a bit higher than the last few years, which were a bit higher than the years that went before them.

14:21And so the question is, what's the unbiased estimate? The unbiased estimate, in other words, something which is equally likely to be wrong on both sides, probably does have a step up in productivity. It's just a question of how hard you want to push that theme. Yes, I suspect that's something we'll be coming back to on Trumponomics, not least because there are even some small signs of a pickup in productivity in the UK where it has been dead and buried for really a long time. So we are waiting to see if those get trampled on in the spring rains. Let's get to his approach to the balance because where he has talked about really wanting to bring in the changes outside of the sort of traditional monetary policy had you set interest rates is in this desire to shrink the balance sheet.

15:04The Fed famously had, I think its balance sheet was less than a trillion dollars before the global financial crisis. It peaked at about nine trillion dollars after COVID. And it has shrunk a little bit as a result of those kind of those sales of bonds that the Fed was holding. But it's still roughly seven or eight times what it was 20 years ago. And that potentially has quite big implications, not for short-term interest rates, but for long-term interest rates, if he aggressively moved to restart the shrinking of the Fed balance sheet, because obviously they had stopped that quite recently. So how do you see that?

15:43And are you concerned about it? Right. Yeah. So first of all, just for your listeners, the Fed's made a bit more progress bringing down the balance sheet from the peak around, I think, as you said, was it$9 trillion? We're down about$6.5 trillion at this point. That's an appreciable reduction. And in terms of the ratio of the central bank balance sheet to nominal GDP, or banking assets, which is a sort of a kind of reasonable benchmark, you certainly unwound the pandemic expansion in the balance sheet. So that part, at least, has round-tripped. But you're absolutely right that if we're looking for one consistent theme across Kevin Walsh's career, it's that he favors a smaller, cleaner, and I would add humbler central bank balance sheet, meaning that it's not just about the size and composition and duration of the balance sheet, but it's also about this idea that a big central bank balance sheet is a form of big government, a big footprint of the government sector in markets, and that this is unhealthy in lots of ways, some of which relate to the encouragement it gives to the fiscal authority to run big deficits and debts, but also that just you don't want a system where the central bank is such a big actor in money markets and in financial markets.

17:00So I think that is a deep-seated and sincere conviction on the part of Walsh. The question is, how should we expect that he will look to try to reflect that during his tenure as Fed chair. I think the idea that Kevin will go out there and try to kick off some big QT program fairly soon is laughably improbable. He is somebody who is quite savvy and understands full well that his greatest point of vulnerability is his past comments about the balance sheet. And if he says anything that sounds too hawkish on the balance sheet or suggests that he might be keen to kick on with QT again fairly soon, he risks a blow up in terms of a spike in bond yields that would not only be a big hit to the start of his career as Fed Chair, it would also blow up his relationship with Secretary Besant and President Trump.

17:50So this is the last thing that Kevin wants. I think Kevin will, as soon as he starts speaking, he will signal that he's going to be very pragmatic on the balance sheet, very careful in terms of what he may try to do on the balance sheet. One mechanism for signaling that to the market is his idea of a Fed-Treasury accord that would facilitate closer institutional cooperation between the Fed and the Treasury. Now, the mention of Fed-Treasury accords makes some us nervous as to exactly how this would affect traditional conceptions of central bank independence. But Kevin will argue that, look, the central bank can be independent, but still coordinate in a more effective or cooperate in a more effective way with the Treasury.

18:33In the here and now, that would be very much, I think, about making sure that any balance sheet plans on the Fed side were consistent with plans on the Treasury's debt management side, if you like, a little bit of sort of soft coordination there. But I think the signal to markets is intended to be that I, Kevin Walsh, am giving Scott Besant a soft veto, not a hard veto, but a soft veto on any QT plans. So you can all relax because you may not trust me, but you know full well that Scott doesn't want higher yields and higher mortgage rates.

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20:26Just to get into that, because you are such a sort of long-term observer and thinker about this particular bit of the market and the kind of interaction of markets with policy of the Fed. You could imagine quite a lot of people in the financial markets would think, yeah, big government's bad. We don't like Fed that gets in the way and gets super involved in lots of different things. On the other hand, some of the people who have talked to me who've been most concerned about shrinking the Fed balance sheet faster have been people who look at the short-term liquidity of treasury markets and the repurchase market, this kind of very short-term liquidity that banks need to keep the financial system ticking over and are worried that if you have over time quite a significant reduction in the balance sheet, that could actually have unexpected consequences that we don't really understand for liquidity in day-to-day markets.

21:15Do you agree with that? I certainly think if it was mishandled, it would have very significant consequences for money markets, as well as potentially the functioning of the treasury debt market itself. That's precisely why Walsh is going to be extremely careful here. So if you forgive me for just being a little bit analytic for a second, Steph, Kevin understands full well that the size of the Fed balance sheet is dictated by the amount of reserves the banks want to hold for any given chosen operating framework that the central bank operates with. So the big change from the pre-financial crisis period to the present is that the Fed moved from what was called a scarce reserves system to what's called an ample reserves system.

22:08In theory, the Walsh Fed could try to, over time, move back towards a scarce reserve system. That would be extremely difficult to implement, operationally very challenging. It would be a massive headache. And it would also involve the kind of Fed portfolio shrinkage over time that would likely put substantial upward pressure on longer term bond yield in a way that would be very much antithetical to what the Treasury and the White House is trying to achieve. We think that the Fed itself would not go along with that, that the vast majority of the FOMC has a sort of settled preference for the ample reserves system.

22:53So our call is that Walsh will not move off the ample reserve system towards the scarce reserve systems. Once you've settled that you're running an ample reserve system, you're going to have a big balance sheet, period. Now, question, how big? Well, that's determined by the second part of the formula I gave you. How many reserves do the banks want to hold for a given operating framework? Now, that may be sensitive to the regulatory regime. What I think is potentially going to happen here, is that Walsh, in concert with the Treasury and the other banking regulatory agencies in the US, will be pushing hard on banking deregulation.

23:35The Fed will also, under Walsh, be pushing hard on easing up on banking supervision, which is the sort of the implementation of the rules, if you like, rather than the rules themselves. And the hope would be that as a result of extensive banking deregulation that makes it cheaper in capital terms and liquidity terms to hold government paper, banks will choose to hold a bit more government debt, including treasury bills, and a bit less by way of bed reserves. To the extent that banking deregulation means that the banks desire less reserves, that would then allow Kevin to reduce the balance sheet some without stressing money markets.

24:24But if he tried to reduce the balance sheet today without changing the framework or banks' demand for reserves in the framework, all that would happen is you would have an immediate return to money market stress of the the kind we saw in October and December, and he'd be back in balance sheet expansion again within a week. He knows that, and that's why it's not going to happen. You're always very measured in what you say, Krishna, but you seem pretty relaxed about a Walsh Fed. We talked about the interest rates. Certainly, he doesn't have an outlandish approach to setting interest rates. And on this question of better coordination with the Treasury, kind of soft coordination with the Treasury over balance sheet policy, a lot of economists have pointed to the possibility that if you have super independent fiscal policy and monetary policy in an environment of a big Fed balance sheet, then you have got quite a strong possibility of one arm of policy getting in the way of the other.

25:20So it doesn't seem crazy to have a degree of coordination. I guess the question is, do we have good coordination, joined up policy versus bad coordination, which is Trump going on true social and demanding interest rate cuts. But you seem to think the balance is going to be a healthy one. I guess the way I would put it is that I think the crude version of concerns about Walsh, which is he's super hawkish on inflation interest rates and he's super hawkish on QT, just don't bear particularly close examination, certainly not in the here and now context. That's not what we should be worrying about.

25:54That doesn't mean that there are no points of vulnerability or things that we should be attentive to in the case of a Walsh Fed. As I indicated earlier, on monetary policy, I think the question is, it's fine and indeed, I think, very legitimate to critique some of the shortcomings of traditional Fed models and backward-looking data dependence. But it's going to be very hard to replace that with something that is coherent and systematic and well-communicated. And that could go badly wrong if Walsh were to turn his back on the old ways of doing business without having figured out a fully coherent set of approach or set of approaches to replace it.

26:35With respect to the balance sheet, I think Walsh is going to be much more careful than many think. Nonetheless, though, we are already paying the price today in markets for Kevin's past comments on the balance sheet and the uncertainty that this has created about, if you like, the Fed's balance sheet reaction function in a wash era. And having lived through the taper tantrum at the New York Fed, where I was a senior advisor, I will tell you that I at least have always taken away from that episode, how potentially dangerous it can be for central banks to try to reset market expectations as to the approach that they're going to take to their balance sheets going forward.

27:20Now, I'm absolutely not predicting a wash-taper tantrum, but I am saying that he is going to have to move very carefully to update and clarify markets and guide markets as to his thinking on the balance sheet himself. And then separately, as you suggested, a Fed Treasury accord has potentially some upsides and potentially some very concerning downsides. And the devil really would be in the detail as to whether this was a sensible vehicle for cooperation, starting from the principle of very firm independence on the side of the central bank, but looking to cooperate where appropriate to implement policy, or whether this would be a vehicle for some erosion of that central bank's independence, the bond market certainly will be wary until we find out exactly which type it is.

28:20At some level, all of this is irrelevant if he doesn't bring a majority of his colleagues on side, at least to some degree. You talked about we're already paying the price in the markets. He's paying the price not just for former comments about the balance sheet, but the fact that he has been chosen by Donald Trump in a very politicized environment where a lot was said about the need to lower interest rates and et cetera, et cetera. So as you said, he has a repair job to do. Everything that we've read about him, we had a very good profile. The Politico had a very good profile. He seems to be not someone who would go in as a bull in a china shop.