Federal Reserve Chairman Kevin Warsh, who took office on May 22, has been particularly vocal about his intention to reduce the central bank's sprawling balance sheet, which he believes borders on fiscal policy. However, despite his repeated calls for deleveraging, the Fed's balance sheet has actually grown from $6.704 trillion to $6.725 trillion, an increase of roughly $20 billion, since his tenure began. This expansion runs counter to his stated goal of reducing the Fed's involvement in the "fiscal business" and has been a source of frustration for the new chair, who has yet to make any headway on this key reform.
Warsh has outlined a comprehensive reform agenda, including changes to how the Federal Open Market Committee (FOMC) approaches inflation, and has launched five specialized task forces to re-examine the Fed's conduct of monetary policy. He has also moved away from forward guidance on interest rates, as evidenced by a considerably shorter FOMC statement in mid-June. However, his most prominent reform, the reduction of the balance sheet, remains elusive, facing a market reality check.
Shrinking the Fed's balance sheet, primarily composed of long-term U.S. Treasury bonds and mortgage-backed securities, would likely depress bond prices, elevate yields, and thus increase long-term borrowing costs. Some analysts, like Raghuram Rajan, have acknowledged the operational hazards of such a move. Conversely, others, including Warsh's external advisors Mervyn King and Marc Andreessen, align with his views on communication and AI's impact on productivity. However, the current market environment, characterized by strong demand for AI chips and GPUs, has led to concerns that higher borrowing costs resulting from balance sheet reduction could impact the debt-financed AI data center build-out and potentially cause a market correction.
Despite the lack of progress on the balance sheet, Warsh continues to advocate for its reduction, stating that it will take "years, not months," similar to the 18 years it took for the balance sheet to reach its current size. He remains committed to a new course for the Fed, emphasizing price stability and expressing a desire for robust internal debate on policy decisions. His efforts to reform communication, with the help of advisors, are expected to lead to greater clarity in the Fed's reaction function, though this may also result in increased volatility in U.S. interest rates.
