Warsh's regime change at the Fed pushes ahead – and meets resistance

Chairman Kevin Warsh likes to measure his tenure as Federal Reserve chairman in days, and 127 days in, his promise of regime change is taking shape. He's moving fast on some easy and very visible items directly in his control but is constrained from making bigger changes by the state of the economy and by his colleagues on the Fed.

Warsh has quickly put his stamp on the way the Fed communicates. Some changes appear cosmetic, such as shortening the news conference that occurs after meetings of the Fed's rate-setting Federal Open Market Committee and changing the seating arrangements for reporters to be alphabetical by news organization. But those cosmetic changes hide a more profound shift: the way Warsh thinks about and communicates his views on monetary policy represents a sharp break from his predecessors.

Warsh hasn't been able to act yet on one of his key priorities, cutting the Fed's balance sheet, in part because inflation is a more pressing concern. And he constrained himself on other priorities by appointing five task forces to examine Fed practices. They are supposed to report back early next year.

Last week's unanimous quarter-point interest rate increase and any ones that follow will likely be the highlights of Warsh's early tenure in a move that answered his critics' concern about his independence from President Donald Trump. Based on how he has explained his way of thinking about markets and the economy, Warsh seems likely to support additional hikes if inflation remains a problem. Last week's increase was the first since 2023.

For a Fed chairman who prides himself on taking signals from the market, Wall Street is sending a strong one. The 2-year Treasury yield traded nearly a full percentage point above the effective federal funds rate on Wednesday, indicating traders expect more rate increases. It's the largest spread of the 2-year over the funds rate since 2023. Inflation is running at 3.7% as measured by the Fed's preferred personal consumption expenditures indicator in July, the most recent reading. It has been above the central bank's 2% target for more than 5½ years.

Fed chairs for years described the funds rate as either accommodative, neutral or restrictive. But asked at his Sept. 16 news conference where the Fed was relative to neutral, Warsh dismissed the very premise. He responded that the concept is "useful academically" but had no bearing on the decision to hike.

The comments caused consternation among some in the central banking world who had been accustomed to thinking of the funds rate in those terms.

"What is odd is that Warsh framed the decision as 'removing a dose of accommodation' and then distanced himself from the concept that defines accommodation,'' wrote economist Claudia Sahm. "But now that the Fed has hiked, how will he judge whether to hike again, and when to stop?"

Warsh's critics argued after his vague performance in July that he lacked credibility because he hadn't articulated a consistent theory for how to set interest rates. Yet a careful look at Warsh's public comments suggests a new regime for determining policy is being gradually articulated.

That regime encompasses a broad array of financial and market indicators. Three times in his Jackson Hole, Wyoming, speech and three more times in his most recent news conference, Warsh highlighted "financial conditions" as a key to his thinking. He said a review of market conditions indicated to him that conditions were not restrictive.

He pointed in Jackson Hole to "the level and change in asset prices across sectors ... the prices and trading volumes of Treasury securities ... the foreign exchange value of the dollar ... the cost and availability of credit ... and the price of a broad set of commodities." Warsh went on to say: "These and other indicators should inform the Fed's near-term outlook on economic activity and inflation throughout the business cycle. They should also reveal the state of broader financial conditions ... and the risks and uncertainties in the financial cycle.''

That logic may strike some as circular, since expectations for the Fed form a large part of financial conditions. So the feedback can amount to the market telling the Fed what it expects the central bank to do.

But taken at face value, the comments indicate scope for further hikes. The stock market remains buoyant; the labor market is robust; most financial conditions indicators continue to show little restraint, either in lending or borrowing. Growth looks to be strong.

The market is sending the same message with the probability of a follow-on hike in October at 70%, and as many as two more priced in from now until March.

Warsh's focus on sometimes arcane market indicators is more intense than previous chairs and somewhat reminiscent of former Fed Chair Alan Greenspan, who was famous for digging deeply into everything from company capital expenditures plans to scrap metal prices.

In his Jackson Hole speech, Warsh said he was watching a suite of indicators for monetary expansion including credit spreads, the Fed's Senior Loan Officer Opinion Survey, which gauges the willingness of banks to lend, and credit availability and demand. His conclusion? Money is easy.

"That helps explain the growth we've seen this year in those loans," he said. "Credit and loan markets are showing few signs of policy restraint." Easy credit conditions would not necessarily require rate hikes. In Warsh's formulation, the central bank could need to lean against a private credit system making credit too easy when inflation is running above target.

"We should pay attention to money created by the central bank and money that comes from the banking and financial systems," Warsh said at Jackson Hole. Continuing loose credit conditions clear the way for further rate increases in Warsh's framework. But hikes will be likely only if inflation remains high along with oil and diesel prices.

"The recent rise in overall commodity prices also bears watching," Warsh said at Jackson Hole. The Bloomberg Commodity Index, a broad measure of commodity prices, is up more than 30% this year. Some energy products are faring worse: diesel has risen 83%.

A slower pace for other Fed officials

It's unclear if other members of the FOMC have cast off the neutral framework and adopted one more closely aligned with Warsh's broad concept of financial conditions. While those conditions have always been part of the way Fed officials have evaluated policy, few speak about them now as much more than just a part of their decision-making. Former Fed Chair Jerome Powell often noted how difficult it was to determine the neutral rate, but still often described rates as "modestly restrictive."

So far, Warsh has been virtually alone in refusing to forecast the outlook for the funds rate in the Summary of Economic Projections, the so-called dot plot. And many board members also continue to offer their outlooks for the economy and rates in speeches and interviews, a practice Warsh has rejected.

That reluctance highlights the slower parts of regime change so far. Warsh inherited his committee and the economy he has to steward, both of which work together to slow the reforms Warsh wants to put in place.

Reform has arguably been slowest on what may be Warsh's longest-standing policy priority. Since at least 2011, Warsh said the Fed should reverse the growth in its balance sheet, now at $6.7 trillion. He hasn't committed to a plan for making that happen, which could mean selling securities the Fed already owns or allowing bonds to mature without replacing them. He quit his first stint on the Fed's board that year because he was uncomfortable with the growth in the balance sheet, though he said he voted for expanding it out of loyalty to the institution.

Now, back and in control of the Fed's agenda, Warsh finds himself unable to quickly follow through on his plans for balance sheet cuts, even though that could in theory have taken more accommodation out of the economy. The FOMC's minutes for July show other voters were reluctant to move quickly toward cutting the balance sheet, preferring to wait for Warsh's task forces to report back.

The state of the economy and the markets also may have complicated Warsh's plans. With inflation above the Fed's target and oil surging, the committee had an immediate need to address prices, making it the wrong time to experiment with whether Warsh was right that cutting the balance sheet would meaningfully restrain the economy.

Meanwhile, the yield on the 10-year Treasury has risen above 5%, pulling up rates on mortgages and other consumer debt with it. That makes this a particularly inopportune time for the Fed to start asking the market to take on additional supply of mortgages and Treasury notes if the Fed were to reduce the balance sheet.