The Warsh Shock: What's Next for the US Dollar, US Stocks, and US Bonds?

This Friday, Kevin Warsh will be sworn in as Chairman of the Federal Reserve at a ceremony held at the White House, presided over by US President Donald Trump.This article's logicI. The Warsh Mix: Interest Rate Cuts, Balance Sheet Reduction, and Financial ReformII. Warshism: The Dollar, AI, and National CompetitionIII. The Warsh Shock: Expectations, Pricing, and Market TrendsThe Warsh Mix: Interest Rate Cuts, Balance Sheet Reduction, and Financial ReformWhat monetary policy mix will Warsh adopt?Due to stringent regulations restricting banks' ability to create money (loans-deposits), market liquidity has become heavily reliant on the Federal Reserve (base money). The Fed has been forced to massively expand its balance sheet, while banks have been forced or have actively held large amounts of reserves.During periods of ample liquidity, the Fed has adopted an interest rate corridor to control short-term interest rates, a method that has fostered a massive risk-free arbitrage market. Banks can borrow cheap funds in the money market and then deposit them as reserves with the Fed through arbitrage. Currently, required reserves have fallen to zero, but excess reserves exceed $3 trillion. This huge amount of capital has been circulating idly for a long time, resulting in inefficient allocation and a flattening of the reserve demand curve. This weakens the Fed's traditional policy tools (interest rates) and constrains its ability to shrink its balance sheet—potentially triggering a reserve panic. In other words, without easing restrictions on banks, the Fed's balance sheet cannot normalize; without easing restrictions on banks, the risk of liquidity depletion caused by balance sheet reduction cannot be mitigated. Warsh's task was to "squeeze" reserves into the credit market by relaxing bank regulations, lowering reserve requirements, and eliminating arbitrage opportunities related to reserves; simultaneously, he aimed to stimulate market demand for credit and inject liquidity into the market by lowering interest rates. The Warsh combination was "tight money, loose credit," using the Fed's balance sheet reduction to boost the dollar, and using interest rate cuts and relaxed bank regulations to release credit and create liquidity. Therefore, balance sheet reduction does not equate to tight liquidity or high interest rates.