Faced with the twin challenges of persistent inflation and a Trump administration demanding direct support for growth, an immediate cut in short-term interest rates would threaten the Fed’s credibility. What, then, are Kevin Warsh’s options for breaking this deadlock?
In a recent opinion piece, Stephen Miran – who chaired Donald Trump’s Council of Economic Advisers before serving briefly on the Fed’s board – praised Kevin Warsh’s first move as head of the Federal Reserve. In particular, he warmly welcomed the two major initiatives announced by the new Fed chair: a return to a more pragmatic approach to monitoring inflation and the reduction of the central bank’s balance sheet. Presented as technical matters, these initiatives are seen as secondary to the expected decisions on interest rates, but they could prove to be key cogs in monetary policy over the coming months.
Indeed, Warsh must contend, at least indirectly, with the constraints imposed by the administration, support growth and continue to finance the US budget deficit, which requires keeping borrowing costs in check. The direct route would be a rapid cut in short-term rates, something Donald Trump regularly calls for. But as long as inflation remains unchecked, cutting rates would signal a loss of independence, reignite inflation expectations and push up long-term rates. This is precisely what the US Treasury wishes to avoid. Another approach must therefore be found, and the two initiatives launched by Warsh appear to offer a fairly sophisticated response to this impasse.
Regarding the first initiative, on inflation, Miran believes it could pave the way for a shift from a numerical target of 2 per cent to a more qualitative objective of price stability. In his view, the measurement of price rises relies on too many arbitrary conventions to justify such precision. The argument is not new, but the consequences of such a change are far from trivial. A numerical target is a public and verifiable commitment. Any overshoot is immediately apparent. Price stability, as assessed by the Fed alone, can only be judged by the Fed itself. The apparent firmness on interest rates would thus be offset by renewed flexibility regarding the inflation target being pursued.
The second area of focus – reducing the size of the Fed’s balance sheet – is the real channel through which monetary policy easing could take place. Miran explains that it is currently difficult to reduce the central bank’s balance sheet because this automatically entails a reduction in banks’ reserve levels, which creates immediate strain on the money market. Since the tightening of regulations following the 2008 financial crisis, banks have been maintaining such high levels of reserves that Miran believes the scope for reducing the Fed’s balance sheet has become too limited. He therefore proposes resolving this dilemma by modifying the ‘plumbing’ of the banking system in order to lower these reserve levels. In particular, he suggests recognising banks’ access to the discount window as a source of liquidity and revising banks’ leverage ratios.
These measures would reduce reserve requirements, thereby paving the way for a more significant reduction in the Fed’s balance sheet and, at the same time, freeing up substantial lending capacity that banks could mobilise to absorb US Treasury issues or support credit expansion. This would thus provide, via the banks, increased potential for financing public debt and possible additional support for economic activity, without affecting interest rates. QED.
The overall logic then becomes clear. The conclusion is that a cut in short-term rates would have enabled both growth and government financing at a controlled cost, but without the detrimental effect that such a rate cut might have had on the Fed’s credibility and, consequently, on long-term rates. A strict stance is maintained on short-term interest rates whilst creating the conditions for greater flexibility regarding the amount of credit available. If the Fed successfully manages both these areas, it will gain greater autonomy in tackling inflation whilst offering banks more flexibility to finance the budget deficit and the country’s growth.
Will Kevin Warsh succeed in meeting Donald Trump’s expectations whilst maintaining the Fed’s credibility, keeping inflation under control and preventing long-term rates from rising? Only time will tell, but he has realised that he cannot have his cake and eat it simply by adjusting the level of key interest rates. Seen in this light, the initiatives he has launched are far from superfluous.