President Donald Trump’s nomination of Kevin Warsh as the next Federal Reserve chair has ended months of uncertainty surrounding the central bank’s future, though it has ushered in a new period of questions regarding the potential consequences for markets of his anticipated policy of interest rate cuts and balance sheet reduction.
According to Atakan Bakiskan, an economist at Berenberg, the new head of the central bank will assume his position with “incentives and ambitions to revolutionize the Fed.”
“Like all other candidates for the Federal Reserve chairmanship, he favors lower rates (which comes as no surprise). What sets him apart is his firm desire for a more agile balance sheet for the Federal Reserve. Warsh wants the Federal Reserve to play a reduced role in financial markets and not maintain an ‘asset-rich, income-poor’ economy that would fuel inequality,” he detailed.
The Berenberg strategist contends that “the Federal Reserve’s bloated balance sheet contributed to containing financial risks and helping Wall Street thrive while the stock market struggled,” raising the question of whether an “abrupt” reduction could have negative consequences for markets.
he points out that “the structure of the Fed and liquidity regulations are too complex (and have develop into even more complex since the Fed shifted from a scarce reserves framework to one of abundant reserves in 2019) for the Fed to abruptly reduce its balance sheet without rewriting regulations and modifying the framework.”
“Doing so could easily cause a crisis in short-term funding markets, especially when the Fed’s overnight reverse repurchase facilities are near zero and bank reserves are already in intensive care thanks to the Fed’s reserve management purchases. In short, without rewriting the manual, the Fed cannot suddenly reduce its balance sheet without ‘breaking something’,” he explained.
Given this situation, he believes that markets “will likely detect any clumsy attempt and penalize it by moving away from U.S. Assets, resulting in a weaker dollar,” and anticipates that “the risk of such an adverse market reaction could curb such attempts.”
WHAT ARE THE ALTERNATIVES?
Bakiskan believes that one of the most direct ways for Warsh to achieve his goal regarding the balance sheet is for the Fed to simply reduce its securities portfolio, though he sees other possibilities that could minimize the impact on markets.
“A more straightforward and less painful alternative would be to change the composition of the Fed’s assets and simply let it consist of Treasury bills. In that case, the Fed’s balance sheet expansion would add to bank reserves with a minimal footprint. It is more likely that the Fed, under Warsh’s leadership, will first adopt this approach before moving on to deregulation (a revision of the Supplementary Leverage Ratio or a recalibration of the Liquidity Coverage Ratio?) and balance sheet contraction,” he predicts.
Taking this into account, he asserts that “the most likely outcome is that a Fed with Warsh will shift the composition of its assets primarily to Treasury bills (with the sole purpose of managing reserves) and gradually move away from other asset classes.”
“Assuming that balance sheet reduction is then carried out gradually, with the rewriting of regulations and adjustment of the regulatory framework, and that the Fed implements a final 25 basis point cut in June under new leadership, as we predict, the yield curve should steepen. The uncertainty stemming from attempts at a regime change at the Fed should result in a weaker dollar,” he adds.
AI AND PRODUCTIVITY
the Berenberg economist points out that “like many others, Warsh believes in a productivity boom driven by artificial intelligence (AI),” which, “combined with some deregulation, should generate enough disinflation and, allow the Fed to further reduce interest rates.”
“This is not a particularly controversial stance, but future productivity gains from the adoption of artificial intelligence are more of a hope than a prediction, as there is simply not much evidence to support it. This approach of waiting for productivity increases is similar to the opportunistic disinflation strategy that the Fed adopted under the presidency of Alan Greenspan in the mid-1990s,” he recalls.
At that time, he continues, policymakers “were not actively seeking to suppress demand to reduce inflation, but rather were hoping for an expansion of the economic supply.”
“While the same can be done this time, Warsh must convince the rest of the committee that a productivity boom is on the horizon. While recent productivity gains have come from industries that have most adopted artificial intelligence in their operations (i.e., information, finance, and professional and business services), it is difficult to determine whether the relationship is causal,” he states.
this analyst believes that “there is still not much evidence to convince the rest of the FOMC committee to trust that AI-driven productivity will offset any potential resurgence of inflationary pressures.”
