Kevin Warsh, the former Federal Reserve governor nominated by President Trump as the central bank’s new chair, has long been critical of the trillions of dollars added to its balance sheet since the financial crisis.
Warsh supported the first round of quantitative easing (QE) in 2008-2010 despite his concerns the Fed was becoming “more of a price maker than a price taker in the Treasury market,” then decided enough was enough. He resigned as a governor in 2011 because of his disagreement about the need for further asset purchases by the Fed.
His view is that the Fed has blurred monetary and fiscal policy through its vast bond purchases and that its inflationary actions have underpinned a profligate state. In a speech at the IMF last April, he argued the Fed’s “institutional drift” had “contributed to an explosion of federal spending.”
“Monetary dominance (where the central bank becomes the ultimate arbiter of fiscal policy) is the clearer and more present danger” than fiscal dominance,” he said.
Trump’s nomination of Warsh as the replacement for current Fed chair Jerome Powell contributed to a steep sell-off in gold and silver and a rise in long-term Treasury yields at the tail end of last week. The reaction was down to Warsh’s perceived hawkishness as a policymaker and the potential implications for dollar assets if he becomes chair (he still needs to be confirmed by the US Senate).
Total assets on the Fed’s balance sheet sit at more than $6.6tn. QE began in response to the global financial crisis and, continuing into the 2010s, the amount purchased rose towards $4.5tn before moderating. It then ballooned to almost $9tn during the Covid-19 pandemic. Quantitative tightening (QT) has since trimmed the asset base, but the balance sheet is still around seven times bigger than in 2007.
Decisions by previous policy chiefs made the Fed the key buyer of Treasuries. Therefore, should Warsh move to slash the balance sheet it would mean a significant lowering of central bank demand for US debt and could lead to higher yields and borrowing costs.
There are reasons to suspect that a major further shrinkage of the balance sheet under Warsh may not materialise, which are primarily down to the liquidity implications of QT. Simply put, reducing liquidity in the market risks delivering higher interest rates, the opposite of what President Trump is after.
Hedge funds need overnight liquidity. The exchange traded fund (ETF) industry needs dollar liquidity. The new stablecoin phenomenon needs liquidity too.
However, supporters of cutting the Fed’s balance sheet have mooted easing banking regulations to push banks to take on more Treasuries and avoid the market liquidity concerns linked to QT. The idea is to shift balance sheet risk from the Fed to the banks. This is something to keep an eye on.
The wider context for Warsh’s nomination is pressure on the US dollar and Treasuries as investors think again about the right level of exposure to the American market.
Blackrock strategists view Warsh’s appointment as “mitigating the risk [of rising real rates] for now thanks to his financial crisis experience and likely focus on preventing global spillovers.”
While our Alpha allocation models have retained significant exposure to US equities through the MSCI World, they remained out of dollar-denominated bonds in February.
The volatility in the precious metals market sparked by Warsh’s nomination highlighted the risks of gold investing but also how well bullion has done over the last two years amid geopolitical ructions.