Wash's three major challenges: the Federal Reserve, inflation, and Trump

Kevin Warsh has been a vocal critic of the Federal Reserve's excessive size, poor inflation management, and compromised independence for the past 15 years. Now, as the next Federal Reserve Chair nominee put forth by Trump, he will have to confront and address these issues personally. On January 31, The Wall Street Journal's chief economic commentator Greg Ip pointed out that if confirmed, Warsh will face three tricky balancing tasks: Reducing the Federal Reserve's balance sheet without disrupting the markets, bringing inflation back down and stabilizing it at 2%, and avoiding presidential interference that undermines the central bank's independence in the process. Each of these is far more difficult than it sounds. Reducing the "Systemic Expansion" of the Federal Reserve Warsh served as a Federal Reserve governor from 2006 to 2011, participating in the response to the global financial crisis under Ben Bernanke. He ultimately resigned in opposition to the "quantitative easing" (QE) policy. QE aimed to lower long-term interest rates by purchasing trillions of dollars in bonds and injecting reserves into the banking system. From 2008 to 2022, the Federal Reserve's balance sheet expanded from $900 billion to $9 trillion, and although it has since decreased, it still stands at $6.6 trillion, which Warsh believes is still too large. Warsh argues that this policy distorts market signals and enables fiscal deficits, ultimately driving up inflation. "Every time the Federal Reserve intervenes, it expands its own size and power," he stated last April. "The more debt accumulates, the more distorted capital allocation becomes, and the institutional boundaries are crossed time and again." This view has been echoed by Treasury Secretary Scott Basset, who has accused the Federal Reserve of "mission creep" and "institutional bloat." However, reducing the balance sheet is not without costs. First, the banking system now relies on ample reserves to maintain financing and market operations. For this reason, the Federal Reserve halted further balance sheet reduction at the end of last year. Second, selling bonds could push up long-term yields, which in turn would raise mortgage rates—this would directly anger Trump, who advocates for low interest rates. Inflation Theory and Internal "Regime Change" At the time of Warsh's nomination, the core inflation rate in the U.S. remains close to 3%, far above the Federal Reserve's target of 2%. He not only needs to propose a plan to lower inflation but must also persuade the "12-member Federal Open Market Committee (FOMC)" to accept it. Unlike Powell, who has an economics background, Warsh's background is in law and finance. He often disparages mainstream macroeconomic models and the "economics guild" behind them, favoring explanations of inflation through indicators such as commodities, stock prices, and money supply. This unorthodox view has raised concerns in the market about internal conflicts within the Federal Reserve. Warsh has hinted at the need for a complete overhaul of the Federal Reserve, stating bluntly last July: "What we need is a regime change at the Federal Reserve... This is not just about the Chair, but about a whole series of people. We need to break the old structure, even to 'break some heads'." Former Federal Reserve Vice Chairman Don Kohn pointed out that while he agrees with some of Walsh's criticisms, he disagrees with his "harsh tone." However, Nellie Liang, who has served at the Federal Reserve, believes that Walsh may be more inclusive than his remarks suggest; he will not be bound by the models of his staff but will also not completely ignore professional opinions. For the market, in the short term, Walsh may be lucky, as the easing of tariffs and housing pressures should drive inflation lower this year. But once the tide turns, Walsh will need to present an inflation theory that can convince both the market and his FOMC colleagues. Who can say "no" to Trump? Walsh's supporters argue that he is more independent than another competitor, White House advisor Kevin Hassett. But the reality is that his appointment comes from a president who openly questions central bank independence. Trump has made a commitment to significantly lower interest rates a condition for his nomination, and Walsh catered to this demand last October, claiming, "We can significantly lower interest rates, making 30-year fixed-rate mortgages affordable." However, the most challenging part of monetary policy is adjusting interest rates based on data. If inflation rebounds, and the data requires the Federal Reserve not to cut rates or even to raise them, will Walsh dare to defy Trump? Trump stated in Davos, "It's surprising how people change once they get the job." This indicates his concern that Walsh may become "disobedient" once in office. Trump's attacks on Jerome Powell—including allowing criminal investigations and attempting to fire board members—have shown that if the Federal Reserve Chair disappoints him, he will not stand idly by. While the Supreme Court may limit the president's power to dismiss the Federal Reserve Chair, Trump can still make Walsh's life difficult through public attacks and by appointing compliant board members. Walsh has acknowledged the importance of independence, stating, "I read in the newspapers how harsh politicians are toward central banks. Well, grow up. Be tough. What’s the secret to central bank independence? Achieve goals and do your job well." For investors, whether Walsh can maintain his principles amid Trump's political pressure and the Federal Reserve's data-driven approach will be the biggest tail risk for the market in the coming years