We need to talk about Kevin: What to expect from the Fed under Warsh

The new head of the Federal Reserve, Kevin Warsh, takes over at a key moment for the institution amid questions about the central bank’s independence. It’s also an important phase in the economic cycle as inflation picks up and questions over the strength of the US economy are being answered. And it’s a key moment for financial markets as investors grapple with the powerful tides of soaring AI investment and corporate earnings against a heightened geopolitical risk profile and stretched valuations.

So, what do we expect from Warsh and the Fed he is taking over?

Warsh takes on the chairmanship after a period of uncertainty and against the backdrop of political pressure on the Fed from the White House. It’s also a period of  significant (relatively speaking) division among Fed policymakers over the path of interest rates. However, the recent uptick in inflation and resilience in the economy is trending towards a higher degree of consensus than may have been the case before the Iran war.

Will he lower rates? President Trump has spent the last year lambasting Warsh’s predecessor, Jerome Powell for, in his eyes, a failure to lower interest rates enough. The main question for the market is whether Warsh is about to do what Trump wants and lower rates.

Warsh indicated in his confirmation hearing that he expects productivity gains from AI to allow for lower rates. However, he assumes the role at a time when the effects of the Iran war are once again pushing up inflation. The effect of AI may well be deflationary, but not yet seems to be the answer. (My own view FWIW is that we are in higher inflation paradigm of 3-4% being the new normal for all kinds of reasons such as deglobalisation, fragmentation, war, etc etc, and it’s not about to go away soon).

Markets have swung decisively away from pricing in rate cuts this year to pricing in a hike by December. My expectation is for the Fed to swing behind a rate hike even sooner due to the strength of the labour market and rising inflation. June will see the FOMC relinquish its easing bias and we could have a hike as early as July. This will form a key test of the Fed’s independence under the new regime for a hike will put Warsh quickly on a collision course with the President.

A simpler Fed: Warsh has been critical of what he sees as mission creep by the Fed; for instance, efforts to address climate change or social inequality have been examples of the central bank getting over its skis in his view. A key change expected under Warsh is for a trimmed-down day-to-day role for the Fed in financial markets. Warsh will reinforce the Fed’s core mandate of price stability and maximum employment. In short, the Fed will keep to its knitting: monetary policy. But whether in reality it is drawn into political debates may rest on the actions of Trump.

Balance sheet reduction: Warsh has been clear that he favours using interest rates as the primary tool for monetary policy, and has indicated a preference to pare the Fed’s balance sheet, which has ballooned to more than $6.7 trillion. A process of actively selling Treasuries – as the Bank of England is currently doing with its stock of gilts – would tend to raise yields, steepen the curve and increase term premia by increasingly the supply of bonds, just as concerns about debts and deficits are increasing.

However, it’s not that simple. Recently Warsh has argued for a new Treasury-Fed accord that could provide a framework for the central bank and Treasury to work together on shrinking its balance sheet. The Fed is now growing its balance sheet having stopped its last round of quantitative tightening in December 2025. 

And the last round of QT was barely noticed by markets – like “watching paint dry” in the words of former Fed chair Janet Yellen. I’d expect the Warsh-led to carefully and mindfully find the right mechanisms for reducing the balance sheet without causing a taper tantrum, such as giving large banks more flexibility outside of reserve holdings and shifting issuance towards short-dated maturities.

A new way to look at inflation: Warsh has been critical of the Fed’s shift in 2020 to flexible average inflation targeting, which allows for temporary overshoots above the 2% target. Warsh favours a stricter adherence to the 2% goal. He has also urged the central bank to look at alternatives to the standard gauges of inflation, such as the PCE and CPI indices. Warsh wants the Fed to pay attention to measures of inflation that strip out the noise from extreme month-to-month movements. Several indicators exist but the most widely cited is the Dallas Fed’s trimmed mean, which was running at 2.3% in April vs 3.3% for the core PCE, the Fed’s current preferred gauge. The Dallas Fed trims more off the top than the bottom of prices, which means it was late to show up the 2021 surge in inflation. The implication is that Warsh may prefer to sit out periods of higher inflation – but it’s unclear whether this will impact policy immediately and we know that any changes to the way the Fed views inflation will not come overnight. We may assume that it means he’s more likely to favour staying easier for longer, or even cutting, but the economic conditions do not seem to favour this scenario right now.

In short, we have no real obvious view on whether he would favour cutting now or not; a stricter adherence to 2% suggests willingness to tighten (allowing for the strictures of the dual mandate), while a preference for the trimmed mean gauge and his stated views on AI indicate a preference for lower rates. And it’s always worth reiterating that the Fed is a committee, not a dictatorship. 

Guidance and forward-looking statements: Warsh wants to end the practice of issuing forward guidance whereby the Fed signals where it expects interest rates to be in the future. This would mark a significant shift from the practice of the past and would be a step-change from what other major central banks do.

“I don’t believe in forward guidance,” Warsh said during his Senate confirmation hearing in May. “I don’t believe that I should be previewing for you what a future decision might be.”

This means the dot plot – where individual Fed members set out where they think rates will be in the future and which has become a key tool for markets to gauge the likely path for rates – could become a thing of the past. Intended initially as a soft form of guidance, it’s becoming a key anchoring mechanism for markets and therefore would be a material change if abandoned.

Going beyond ditching the dot plot, Warsh is also likely to abandon the use of language in the Fed’s statements that indicates the path for rates – the ‘bias’ as it’s commonly referred to. 

The Fed maintained an easing bias last month but a trio of dissenters - Neel Kashkari, Beth Hammack, Lorie Logan wanted to remove from the statement in May. Since the last meeting Christopher Waller and Lisa Cook have also said they believe the easing bias should be dropped from the FOMC statement. Given the shift within the committee it could allow Warsh to do something new and drop all guidance language from the June statement.

This of course presents potential problems – how do financial markets react to an abrupt change in the way the Fed communicates? 

The first indication of what’s in store is likely at the June 16/17 meeting. While Warsh may be intent on sweeping reforms, it will not be instant: the 19 members of the FOMC all have a voice. He will need to build consensus and reforms will require working groups to look at changes and their implications. 

Dropping the bias language from the June meeting to a more neutral stance will align with how increasingly members are feeling about the economy and inflation. But further reforms will take longer. This may be all that he can effect immediately, but the market focus will be on what path policy rates take – on that front it may be increasingly difficult for Warsh to avoid tightening sooner than expected, despite what Trump may want.