For more than a decade, Kevin Warsh has advocated reining in the Federal Reserve’s pivotal role in the nation’s financial markets.
Now, as President Donald Trump’s choice to lead the Fed, he may finally get the chance to do that, aided by a Treasury secretary with the same goal. And Wall Street is obsessed with finding out what comes next — bracing for the possibility of extensive market disruptions.
Warsh has bemoaned the Fed’s purchase of trillions of dollars in U.S. government debt and bundled mortgages after both the 2008 financial crisis and the 2020 pandemic, a process that kept longer-term interest rates down to boost the economy and flooded banks with cash reserves.
That policy, he says, has distorted the market and enriched Wall Street rather than ordinary Americans by propping up stocks and bonds, which are overwhelmingly owned by the wealthy.
But any effort to significantly reduce those holdings runs the risk of spiking interest rates and rattling the funding markets that underpin the financial system. So, to pull off any reform, he knows he will have to proceed with a lot of caution.
“The transition to what I think is a more prudent system will take time, deliberation and an excess of communication with the public and the institutions in the banking system itself,” Warsh said last year at an event hosted by Stanford University’s Hoover Institution, where he is a visiting fellow.
The dangers for Warsh run in multiple directions. Any turbulence that pushes up longer-term rates would clash with Trump’s goal of decreasing borrowing costs for the government and lowering mortgage rates. And Warsh will have to convince his colleagues on the Fed’s rate-setting committee to back any changes he’s proposing, which is no guarantee.
Speculation about the path of future Fed policy is heating up as the president is eager to juice both the housing market and the broader economy in the run-up to the elections, with polls showing that voters are souring on his handling of pocketbook issues.
What’s more, the ultimate result of reforms by Warsh might cause market turmoil with little perceptible gain. That has some money market observers questioning whether reform is actually coming at all.
“I don’t think the costs are going to be worth the benefits, and I think they know that,” said Julia Coronado, founder of MacroPolicy Perspectives.
Critics like Warsh argue that the Fed’s purchases not only pushed up asset prices in the wake of two severe recessions, but also distorted those prices. A Brookings Institution paper found that, during the Fed’s market intervention after Covid, the average home value rose nearly $100,000 — nearly 75 percent above the pre-pandemic trend.
That view is not shared by other Fed officials and observers, who instead say the effects of the central bank’s purchases disappear over time and also point to many other factors that have led to rising stock and home prices.
Treasury did not respond to a request for comment. Warsh did not provide a comment.
Warsh, if he is confirmed by the Senate, will have a crucial ally who could help facilitate an overhaul of Fed policy while mitigating the market impact: Treasury Secretary Scott Bessent, who last year wrote a 5,000-word magazine article advocating for a new approach to the Fed’s asset purchases.
Collaboration between Bessent and Warsh could eventually yield changes that are minimally disruptive. (Warsh has already suggested he wants more coordination between Treasury and the Fed.)
Here’s one approach: If the Fed heavily shifted its portfolio into U.S. government debt securities that mature more quickly, and the Treasury Department issued more of that short-term debt, that could actually lead long-term rates to go down. That’s particularly important because long-term Treasury yields feed into mortgage rates.
“But there are probably limits” to that approach, said Patricia Zobel, who used to be a top staffer overseeing the Fed’s balance sheet at the New York Fed. After all, the more quickly the government’s debt rolls over, the more Treasury is subject to fluctuations in rates, said Zobel, now head of macroeconomic research and market strategy at Guggenheim Investments.
Beyond that, Warsh might have to get more creative to avoid causing a surge in borrowing costs or problems in markets.
One important factor is the level of cash reserves banks need to keep the financial system running smoothly. The more the Fed decreases its bond portfolio, the more reserves it removes from the banking system, and eventually there won’t be enough funds to go around.
The government has at least one important lever for reducing that demand: Regulators could loosen rules that dictate how much cash banks need to have on hand, which could allow the Fed to shrink its holdings on the margins.
Other changes could be more cosmetic. The Fed could have a slightly smaller balance sheet if Treasury decided to keep less cash in its account at the central bank, and the result wouldn’t have a significant impact on markets. It would also mean the U.S. government has a smaller buffer during emergencies, though.
“That has zero benefits other than doing what you said you were going to do in terms of being able to point to a chart of total Fed assets going down,” said Lou Crandall, chief economist at research firm Wrightson ICAP.
Ultimately, the question is whether Warsh is really aiming to fully reset the Fed and return to its pre-2008 approach to rate policy, which would necessitate an overhaul of the balance sheet. Bessent, for his part, told reporters in October that he’s not intending to do that.
He also said on Fox News last week that the Fed would likely take “at least a year” to determine the path forward for the balance sheet.
But Bessent and Warsh have both suggested there might now be a much higher bar for extensive asset purchases, known as quantitative easing, in future downturns. That policy shift wouldn’t affect the current size of the Fed’s holdings but would still ripple through markets as they priced in less intervention from the central bank if a recession were to hit.
“I think they could declare victory if they simply entrenched the idea that we’re not going back to QE anytime soon,” Crandall said.
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