Warsh’s Plan to Change the Fed

Kevin Warsh, President Trump’s nominee for the next Fed Chair, testified in front of the Senate earlier this week. Our Global Head of Fixed Income Research Andrew Sheets presents key takeaways from the two-and-half-hour testimony.

Read more insights from Morgan Stanley.

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Andrew Sheets: Welcome to Thoughts on the Market. I'm Andrew Sheets, Global Head of Fixed Income Research at Morgan Stanley. 

Today on the program, a first look at potentially the next Fed chair. 

It's Friday, April 24th at 9am in New York. 

Financial markets can often struggle to keep track of more than one story at a time – and at present, we're really pushing the limit. At one end, the Iran conflict continues to create a historic disruption in global energy markets. At the other, signs of corporate animal spirits and activity hint at the potential for an even larger boom if this disruption ends. 

Merger activity, capital spending, loan growth and earnings growth are all strong and accelerating. And so, into this mix enters a third story, the Federal Reserve. Indeed, both Iran and the investment boom introduce real questions as to how a central bank should react to these factors. 

For example, if oil prices spike further, should the central bank raise interest rates to counter the inflation that would follow? Or should it lower them because that increase in oil prices could potentially hit growth? And what about corporate aggression? As that aggression increases, should the Fed look to raise interest rates and take away the punch bowl, so to speak, to avoid an even larger overheating in the economy? Or maybe all of this investment will create abundance – actually lower prices and warrant interest rate cuts. 

These questions will weigh on the Fed and, in particular, Kevin Warsh, who has been nominated by President Trump to be the next chair of the Federal Reserve. This week saw Warsh testify in front of the Senate as part of that process, giving us the most detailed insight into his current thinking that we've had so far. 

Two things really stood out. First, Warsh believes that this historic boom in AI and technology investment really is likely to boost productivity. A productivity boost, all else equal, should mean a greater supply of goods and services into the economy from the same number of workers; and thanks to that greater supply, relatively lower prices and less inflation. This belief in investment driven productivity underpins why he thinks interest rates can be lower even if current inflation is elevated. 

Second, Warsh was critical of the Fed, stating that it had “lost its way,” from expanding its balance sheet too much to being too slow to reign in inflation following COVID. He outlined a sweeping agenda for change, including how the Fed could forecast inflation, manage its assets, and communicate its policy. 

But another challenge that's going to be facing the next Fed chair will be personal as much as it's economic. Fed decisions are made by a majority vote. And while Warsh may feel strongly that the historic investment cycle that we're seeing in technology will bring down inflation, can he convince others of this as well – especially at a time when current inflation readings are somewhat elevated? And will his criticism of how the Fed has conducted action over the last several years make it harder to gain the support of colleagues, some of whom were there for those measures? Or will it be welcomed as a breath of fresh air and a chance for the Fed to have a new start? 

The uncertain timing of the handover and the fact that policy is still up to committee means that we think markets will likely stay focused on other factors in the near term and expect relatively modest shifts in Fed policy for now. But it's still worth watching. 

Since 1979, only five individuals have occupied this important seat leading the U.S. Central Bank. We may be about to get the sixth. 

Thank you as always for your time. If you find Thoughts of the Market useful, let us know by leaving a review wherever you listen. And also tell a friend or colleague about us today.