The Warsh Reset and Four Ways the Fed Could Change

When the Federal Open Market Committee convenes this week, it will mark a milestone unseen in nearly eight decades: a sitting chair and a former chair conducting business together. The last comparable case was Marriner Eccles in 1948, making Jerome Powell the first outgoing chair in nearly 80 years to remain as a voting governor. The joint presence of past and present leadership adds both symbolic resonance and practical complexity to a meeting already set against a sensitive economic backdrop.

Markets are bracing for a regime shift under incoming chair Kevin Warsh. His philosophy promises to reshape the Fed’s communication, inflation signals, balance-sheet policy and employment framework, each representing a structural break from the Bernanke-Yellen-Powell era.

Communication Strategy
During his Senate hearing, Warsh stressed his desire for a regime shift in the Fed’s communication strategy, leaning towards "strategic ambiguity", questioning the value of regular post-meeting press conferences and arguing for fewer speeches from Fed officials.

Importantly, Warsh does not believe in forward guidance, blaming it for compounding the "inflation is transitory" mistake of 2021–2022. As such, expect him to downplay the importance of the SEP and dot plots, at least until he can convince a majority of the FOMC to move away from them.

Specifically, he sees no role for frequently changing Fed metrics, data dependence, near-term forecasting or forward guidance. These hallmarks of the Bernanke-Yellen-Powell era do not sit well with Warsh, and he appears to favour a return to a Greenspan-style communication strategy.

That phrase, "central bank fast food", is Warsh’s colourful way of criticising what he sees as the Fed’s overreliance on constantly shifting metrics. In his own words, his "first beef" is with the frequent changes to Fed benchmarks, which he argues create confusion for markets and dilute credibility.

Inflation Signals
Warsh’s preference for trimmed-mean measures rather than the traditional core PCE highlights an important methodological debate. Trimmed-mean measures, such as the Dallas Fed’s trimmed-mean PCE and the Cleveland Fed’s 16% trimmed-mean CPI, deliberately exclude the most extreme price changes each month, aiming to capture the underlying inflation trend without being distorted by volatile categories such as food or energy.

Warsh’s stance has effectively reframed the inflation debate. Instead of closely tracking core PCE and the components of PPI that feed into this computation, markets will increasingly watch trimmed-mean measures as a more accurate gauge of underlying price pressures. This shift could materially alter monetary policy expectations should trimmed measures diverge from other inflation gauges.

Balance-Sheet Policy
Warsh thinks that since 2008 the Fed’s footprint in the economy has become too large. At his confirmation hearing, Warsh noted that the Fed’s balance sheet of roughly $7 trillion is almost ten times larger than the roughly $800 billion size that prevailed before the Global Financial Crisis.

In his IMF lecture last year, Warsh said he supported Quantitative Easing 1 during the global financial crisis, but pointed out that when the crisis ended, the Fed never retraced its steps. What began as an emergency measure has become a permanent feature of the policy landscape.

To reduce the asset side of the balance sheet, one must make a corresponding reduction on the liability side. Reserve balances, currently around $3.1 trillion of the Fed’s $6.7 trillion in liabilities, make up the bulk of those liabilities and are directly controlled by the Fed. By contrast, the other two large liabilities on the Fed’s balance sheet, currency in circulation and the Treasury General Account, are largely outside the Fed’s control. To shrink the Fed’s balance sheet meaningfully would therefore require a reduction in reserve balances.

Reserves are the funds that depository institutions hold in accounts at the Fed. Before the 2008 global financial crisis, reserves totalled just $17 billion of the Fed’s $890 billion in liabilities. The surge in reserves reflects large-scale asset purchases, the Fed’s shift from a scarce-reserves to an ample-reserves framework for controlling short-term interest rates, and tighter bank liquidity regulations.

Such a regime shift would require a different policy-rate framework from the one the Fed currently operates. With ample reserves, the IORB and the ON RRP effectively steer the federal funds rate and keep it within the target range desired by the FOMC. With scarce reserves, the federal funds rate is determined more directly by demand and supply conditions, creating a transition phase that could disrupt money markets. Money-market rates could become significantly more volatile during such an adjustment.

There has long been an argument that paying IORB is a subsidy to banks, ultimately funded by taxpayers. However, it could equally be argued that not paying IORB amounts to a tax on banks.

Does this imply a return from an ample-reserves framework to a scarce-reserves framework? Could it even herald the end of interest on reserves? These questions are likely to become increasingly important under a Warsh-led Fed.

Inclusive Employment
Aiming to preserve broad labour-market gains among US minority groups during the previous decade, Jerome Powell in 2020 engineered a historic commitment to maintain that progress by giving "broad-based and inclusive" employment a status equal to, if not greater than, the central bank’s commitment to low inflation.

The FOMC amended its framework document to state that maximum employment is a broad-based and inclusive goal. It also indicated that policy would respond primarily to employment shortfalls, rather than to concerns that labour markets might become excessively tight.

However, many commentators have argued that this more aggressive interpretation of maximum employment contributed to the Fed’s reluctance to raise rates in 2021 when inflation began to accelerate.

Of course, more recently, the term "inclusive" has become almost taboo in Warsh’s policy circles. Warsh argues that "the new nomenclature of inclusive employment was understood to underscore the Fed’s willingness to accept higher inflation so that certain groups would achieve higher rates of employment."

Although the FOMC has never explicitly accepted higher inflation merely to help particular groups find jobs, it has at times tolerated higher inflation in pursuit of stronger overall employment outcomes.

Warsh will almost certainly revisit the concept and seek to re-establish a framework that emphasises the absence of any durable conflict between price stability and maximum employment.

Warsh as Fed chair signals a potential regime shift that could unfold across all four dimensions. The critical question is whether he will implement his own policy convictions or align himself with the more conservative consensus among the other voting members.

Nevertheless, there is little doubt that Warsh believes in an independent Fed, albeit a more restrained one, without mission creep and without a bloated balance sheet.

Markets should therefore prepare not merely for a change of leadership, but for a possible change in the intellectual architecture of US monetary policy itself.