The Fed under Warsh: A policy of incoherence

Fed policy should be clear and consistent. Unfortunately, that doesn’t seem to be what Warsh is likely to deliver.

Sorry to say, but it looks like Kevin Warsh is going to be Jerome Powell’s successor as the Chairman of the Federal Reserve Board. I say, “sorry to say” because he’s not the right man for the job. Besides his apparent eagerness to ingratiate himself with Trump to get this nomination, I don’t think what he says about the future direction of the Fed makes much sense. Specifically, Warsh seems to talk about the Fed’s control of interest rates and the management of its balance sheet as if they were two, unrelated management levers. I don’t see it that way.

The financial crisis of 2008 brought about a change in the way the Fed operated, where “quantitative easing” became a thing. This new approach expanded the instruments that the Fed was able to buy or sell. Additionally, the Fed began paying interest on the reserves that depository institutions deposit with the Fed.

These two changes marked an institutional transition; but conceptually, the Fed remains constrained in a manner that ultimately comes down to easing or tightening monetary policy. These days, easing generally means lowering interest rates, which the Fed can do directly by adjusting the interest rates under its control: the rate paid on reserves that depository institutions leave with the Fed and the rate that these institutions would have to pay when they borrow from the Fed’s discount window.

In addition, the Fed also influences interest rates through its open market operations. When the Fed buys securities in the open market, it bids these prices up and lowers interest rates; and conversely, when it sells securities, it depresses those security prices and raises interest rates. (Prices of notes and bonds are inversely related to their respective interest rates.) With quantitative easing, the set of acceptable securities that the Fed could buy or sell expanded, now allowing for mortgages or mortgage-backed securities to be acceptable securities that the Fed, previously, wasn’t permitted to transact.

When Warsh bemoans the fact that the Fed’s balance sheet is “too large,” I believe he sees these mortgage holdings as being excessive. In fact, adding these longer-term assets to the holdings of the Federal Reserve gives the Fed the capacity to influence a broader span of interest-rate categories and maturities than was permissible with a more restrictive set of allowable assets. In any case, actively reducing the size of that position through asset sales means selling those assets and draining the economy of liquidity — a tighter monetary policy.

At the same time, Warsh continues to avoid any repudiation of Trump’s policy prescription calling for interest rates to be reduced. In this regard, Warsh seems to be favoring an easy (or easier) monetary policy. In general, however, shrinking the Fed’s balance sheet and simultaneously lowering interest rates would serve to push the economy in opposite directions. One action is contractionary policy and the other is expansionary.

Prudent management requires management of the balance sheet and management of interest rates to be done in harmony. Thinking about them as being distinct or independent of each other is a recipe for chaos, where the direction of the Fed and the course of monetary policy would be inappropriately ambiguous. This path seems to be the one that Warsh would be setting out on.

In current circumstances, the world economy appears to be in jeopardy largely due to the closure of the Strait of Hormuz, with economic growth being curtailed in many nations across the world. Thus far in America, however, the effects on the U.S. economy have been fairly contained. The economy continues to grow, and unemployment remains at a relatively low rate. The prospects for inflation, on the other hand, have become more concerning.

This pairing suggests that of the two concerns of the Fed — inflation versus unemployment — constraining inflation should be the Fed’s priority, which means, if anything, the Fed should be leaning toward tightening, rather than easing, financial conditions. Tightening, however, would likely involve reducing the size of the Fed’s portfolio (i.e., open market sales) and higher interest rates — a prospective course of action that Warsh has yet to sign onto. The fact that he can’t seem to bring himself to articulate a coherent way forward is concerning, to say the least.