Kevin Warsh and Regime Change
Doug Nolan
I admired Kevin Warsh during his term as Federal Reserve governor (2006 to 2011).
While young, he was more the traditional central banker operating within an experimental Bernanke Federal Reserve.
He has been pilloried for his inflation focus in the months leading up to the 2008 crisis.
The Fed aggressively slashed rates despite elevated inflation, an easing of financial conditions that spurred ongoing “terminal phase” Bubble excess and deepening systemic fragilities.
Warsh’s inflation focus was justified.
Kevin Warsh has also been criticized for his cautious approach to QE.
While working closely with Chair Bernanke to implement the Fed’s 2008 Wall Street bailout, he argued in September 2009 that the Fed should begin reversing extraordinary crisis-period liquidity injections.
He pushed back in 2010 against Bernanke’s move to restart QE.
From Ben Bernanke’s “Courage to Act”:
“Kevin Warsh had substantial reservations...
He had supported the first round of securities purchases, begun in the midst of the crisis.
Now that financial markets were functioning more normally, he believed that monetary policy was reaching its limits, that additional purchases could pose risks to inflation and financial stability…”
Warsh voted with Bernanke on adopting QE2, but the following week (November 8, 2010) penned a thoughtful op-ed piece for the Wall Street Journal.
Excerpts from “The New Malaise and How to End It:
Given what ails the economy, additional monetary policy measures are poor substitutes for more powerful pro-growth policies”:
“Fiscal authorities should resist the temptation to increase government expenditures continually in order to compensate for shortfalls of private consumption and investment.”
“Pro-growth policies include reform of the tax code to make it simpler, more transparent and more conducive to long-term investment.
These policies also include real regulatory reform so that firms—financial and otherwise—know the rules, and then succeed or fail.”
“The deleveraging by our households and businesses is not a pattern to be arrested, but good prudence to be celebrated.
Larger, more liquid corporate balance sheets and higher personal saving rates are the reasonable and right responses to massive government dissaving and unpredictable government policies.
The steep correction in housing markets, while painful, lays the foundation for recovery, far better than the countless programs that have sought to subsidize and temporize the inevitable repricing.”
“Monetary policy also has an important role to play.
However, the Federal Reserve is not a repair shop for broken fiscal, trade or regulatory policies.
Given what ails us, additional monetary policy measures are poor substitutes for more powerful pro-growth policies.
The Fed can lose its hard-earned credibility—and monetary policy can lose its considerable sway—if its policies overpromise or under deliver.”
“The Fed’s increased presence in the market for long-term Treasury securities poses nontrivial risks that bear watching.
The prices assigned to Treasury securities—the risk-free rate—are the foundation from which the price of virtually every asset in the world is calculated.
As the Fed's balance sheet expands, it becomes more of a price maker than a price taker in the Treasury market.”
“Responsible monetary policy in the current environment requires attention not only to near-term macroeconomic conditions, but also to corollary risks with long-term effects.”
It would be a different world today had the Bernanke Federal Reserve not doubled the Fed’s balance sheet between November 2010 and November 2014.
Financial, economic, social, and geopolitical stability would have been better served if the Yellen Fed had not held short-term interest rates below 1% through 2017 – still held below 2% a decade after the crisis.
It is possible to imagine global central bankers not trapped by historic speculative leverage and Bubbles.
Kevin Warsh demonstrated sound judgment during an extraordinary period, pushing back against the Fed’s inflationist mindset.
Like Powell, I believe he is a man of integrity.
And as I pledged when Powell became Fed Chair, I will support Chair Warsh against future assertions of his responsibility for inevitable crisis dynamics and Bubble collapse.
That said, I am much more comfortable with the old Warsh’s analytical and policy framework than New Age Kev.
From his December 16, 2025, WSJ piece, “The Federal Reserve’s Broken Leadership:”
“AI will be a significant disinflationary force, increasing productivity and bolstering American competitiveness.”
I am reminded of the late-nineties Bubble dynamic, when Alan Greenspan adopted analysis that technology, innovation, and the resulting productivity boom had fundamentally increased the economy’s “speed limit.”
It was a fateful distraction from precariously loose financial conditions and inflating asset Bubbles – an expedient that rationalized the lack of courage to rein in late-cycle Bubble excess.
Inflation has been above target for five years.
There are indications that a historic AI spending boom poses significant inflationary risk (i.e., prices of electricity, semiconductors, copper, commodities, etc.).
The unfolding AI arms race and broader capital investment boom unfold these days at a time of relative labor market tightness.
In short, it’s a suspicious juncture for Kevin Warsh to morph New Paradigm Dovish.
Warsh:
“The Fed should re-examine its great mistakes that led to the great inflation.
It should abandon the dogma that inflation is caused when the economy grows too much and workers get paid too much.
Inflation is caused when government spends too much and prints too much.
Money on Wall Street is too easy, and credit on Main Street is too tight.
The Fed’s bloated balance sheet, designed to support the biggest firms in a bygone crisis era, can be reduced significantly.
That largesse can be redeployed in the form of lower interest rates to support households and small and medium-size businesses.”
“The Fed is an institution whose reach has extended far beyond its grasp.
Fundamental reform of monetary and regulatory policy would unlock the benefits of AI to all Americans.
The economy would be stronger.
Living standards would be higher.
Inflation would fall further.
And the Fed will have contributed to a new golden age.”
Warsh, now the seasoned political animal, Thursday said what he had to say in the Oval Office to secure the job.
A lot will happen between now and May and beyond, assuming Senator Thom Tillis follows through on his threat to hold up Warsh’s confirmation until the Department of Justice is “completely done” with its Powell investigation.
I don’t envy him.
He’ll have the President breathing down his neck, while others question his motives and integrity.
January 30 - Wall Street Journal (Alex Leary):
“President Trump indicated continued support for the Justice Department's criminal investigation into Federal Reserve Chair Jerome Powell, despite a vow from a key GOP senator to oppose Kevin Warsh’s nomination to replace Powell until the probe is resolved.
‘He’s either incompetent or he… is a crook, and we’ll find out,’ Trump said of Powell on Friday…”
Music to the President’s ears, Warsh has repeatedly called for “regime change” at the Fed.
It’s only been one day, but the odds much favor regime change taking hold first in the financial markets.
In a week where monetary disorder was in full force, Friday’s instability was unnerving.
After trading intraday Thursday to $5,595, spot gold was 16% lower at Friday’s lows (ended the session down $481, or 8.95%) – the “biggest intraday decline since the early 1980s.”
Silver (“a record intraday decline”) made gold look placid.
From Thursday’s highs ($121.65) to Friday’s lows ($73.96), Silver collapsed 39% (ended session down $30.50, or 26.36%).
Platinum highs to lows registered at 28.4%, with Copper suffering a 12.5% swing.
Platinum ended Friday’s session down 16.95%, with Copper losing 4.51%.
Other markets take note.
The Semiconductors ended Friday’s session down 4.6% from Thursday's highs (down 3.87% for the session).
After trading at 16 in early Thursday trading, the VIX (equities volatility) Index touched 18.5 mid-session Friday.
Interestingly, the iShares emerging markets ETF (EEM) dropped 3% from Thursday's highs.
The Dollar Index rallied 0.74% Friday, while 10-year Treasury yields were little changed.
Market expectations for the year-end fed funds rate declined five bps to 3.11% (implying 53bps of rate reduction).
It was a curious market reaction to the Warsh news.
While Kevin Warsh is still described as a “hawk,” markets assume he’ll push for lower rates.
He’ll lead a deeply divided FOMC in a period of extraordinary instability – equipped with the experience, skill and demeanor to pull it off.
But it’s balance sheet policy that will stir restless nights on Wall Street.
Going back to 2008, Warsh has been skeptical of Fed “money printing.”
And, for 18 years, the Fed repeatedly pushed the envelope of QE liquidity injections and market support operations.
2008’s $1 TN morphed into 2010/14’s $2.5 TN, to the pandemic’s $5 TN.
Any concern that elevated inflation might restrain the Fed’s printing press was allayed with the response to the March 2023 banking liquidity crisis.
Here's the problem: Pricing across the financial markets now fully discounts open-ended QE.
Risk perceptions are monumentally distorted by the assumption that the Fed will do whatever it takes to backstop marketplace liquidity.
And the greater speculative Bubbles inflate, the greater market confidence the Fed knows it has no alternative than to respond immediately and aggressively to market instability.
It's only a matter of time before the Fed’s balance sheet gets much larger.
With speculative Bubbles over recent years succumbing to blow-off dynamics, to stabilize a serious bout of speculative deleveraging would now require Trillions of QE.
The Warsh Fed will surely accommodate, but the key issue will be whether they will open the monetary floodgates fast enough to reverse deleveraging before panic erupts.
Bloomberg (Maria Eloisa Capurro):
“According to Warsh, models used by the Fed to interpret economic data are wrong: ‘They believe that inflation is driven by consumers, by wages that are rising too much, and consumers that are spending too much,’ he said.
‘I fundamentally disagree.
At the core, I think inflation comes about when the government spends too much and prints too much’.”
On the topic of Fed models, Chair Powell’s press conference offered interesting commentary.
In back-to-back seemingly unrelated questions, the Fed Chair was asked about precious metals prices and then about the Fed’s economic models.
CNN’s Matt Egan:
“As I'm sure you've noticed, gold and silver prices have experienced historic gains of late, and I’m wondering how much attention, if any, you pay to those moves, and what message you may take from these significant price increases we've seen for precious metals?”
Powell:
“Don’t take much message macroeconomically.
The argument can be made that we’re losing credibility or something, it’s simply not the case.
If you look at where inflation expectations are, our credibility is right where it needs to be.
So, we look at those things, we don’t get spun up over particular asset price changes, although we do monitor them, of course.”
Barron’s Nicole Goodkind:
“Some prominent critics have charged that the Fed’s economic models are somewhat backward looking, but should be more forward looking, incorporating things like productivity increases from AI.
How do you incorporate current and future developments into your analysis and decision-making, and do you have an answer to those critics?”
Powell delivered a somewhat lengthy response, which included “what an economic model can do is it can grind up all the data for the last number of years, 50 years let’s say, and it can identify what are the relationships between variables A, B, C, D and all that kind of thing.
And it can tell you if you change one of those variables, this is what should happen in the macroeconomy.
That’s just the way it works.
However, the structure of the macroeconomy is constantly changing.
For example, we hadn’t had a pandemic in 100 years.
It wasn’t in the model.
And we knew it from the very beginning, it was not in the model.
A trade war of this scope, we’d never had that in 100 years…
So, it’s very much on our minds, and we are well-aware that higher productivity means higher potential output, and it changes the way you think about potentially inflation growth, labor market, and all those things.
That’s all in our models.
I mean, if it’s a question of using better models, bring them on.
Where are they?”
How can the Fed not view the parabolic rise in precious metals prices as an unmistakable warning of excessively loose conditions and acute monetary disorder?
Moreover, econometric models that do not incorporate financial conditions variables will be hopelessly deficient, especially at critical cycle junctures.
It’s surely not what Warsh has in mind with “regime change,” but the Fed’s analytical and policy frameworks need radical reworking.
Economies, markets, and finance undergo momentous change.
What’s more, models will never incorporate unpredictable events and developments.
And while sources and dynamics change over time, financial conditions always play a central role in system development and stability.
Market and speculative dynamics have come to dictate system financial conditions, rendering econometric models impotent.
The Fed will continue to fail in its overarching responsibility of safeguarding system stability until it commits to a major analytical framework overhaul.
It’s difficult to imagine more deeply distorted risk perceptions.
January 27 – Bloomberg (Rose Henderson):
“Investor appetite for risk is the highest in five years as optimism about the economy counters geopolitical uncertainty, according to Goldman Sachs…
The bank’s risk appetite indicator hit 1.09 last week, the highest since 2021.
It’s in the 98th percentile of readings for the gauge dating back to 1991, the strategists wrote...
‘Such elevated levels of risk appetite are rare,’ the Goldman team said, pointing to only six other examples of readings above 1.0.
Still, this is not necessarily a signal to turn bearish.
‘Equity returns can be sustained by a supportive macro backdrop,’ they said.
Most components of the Goldman index show a positive stance toward risk…”
This most prolonged period of inflationism and Bubble excess has fostered such deep structural maladjustment.
January 29 – Axios (Madison Mills and Sara Fischer):
“With AI presenting a looming entry-level job crisis, and more tools available than ever to make a quick buck on your phone, Gen Z is becoming America’s ‘get rich quick’ generation.
The American dream is no longer defined by years of hard work paying off with a home and job security.
It’s now about hope for a big break after taking bigger risks.
The rise of billionaire creators such as MrBeast is also inspiring younger generations to try to build massive wealth by building big followings on social media…
The rise of mobile apps for online betting, retail investing and video creation over the last five years has made it easy for young users to access industries that historically required access to a casino, Wall Street trading floor or studio.
Online betting is skyrocketing, and it’s not just about sports anymore…
Retail investing through apps like Robinhood is soaring as young people view the stock market as another form of income, a bet that has paid off amid the AI-driven rally…
Influencer is the top profession that Gen Z says it aspires to, with more than half of Gen Z and millennials in a survey saying they would choose a social media career over any other profession…”
And there’s every reason to anticipate even more precarious Monetary Disorder.
January 24 – Associated Press (Brian Slodysko):
“President Donald Trump’s federal housing finance director, Bill Pulte, quietly granted government-backed lenders the authority to nearly double a $200 billion bond purchase that Trump ordered to try to lower mortgage rates, a move that could introduce a new level of risk for the companies.
An email obtained by The Associated Press that was sent by the Federal Housing Finance Agency to top officials at Fannie Mae and Freddie Mac eliminated caps that prohibited the lenders from each holding more than $40 billion in mortgage bonds.
The Jan. 12 email says that ‘effective immediately’ the new amount of mortgage bonds that they could hold in their portfolios was raised to $225 billion apiece.”
It’s so ironic that Kevin Warsh and Scott Bessent both lament the Fed’s oversized balance sheet.
Deleveraging risk is elevated.
Crypto deleveraging intensified this week, increasing contagion and liquidity risks across markets.
The big tech stocks appear at heightened deleveraging risk.
Meanwhile, Treasuries and global bonds remain vulnerable.
With Warsh waiting in the wings, Powell must pray that he can get through the end of his term without a major market blowup.
Four weeks in, everything points to an unbelievable year.
0 comments:
Publicar un comentario