If confirmed, Kevin Warsh takes over the Federal Reserve just as the global economy is accommodating seismic changes in international security arrangements and how new technologies drive productivity growth and stress workers.
Central bankers’ primary tasks remain unchanged: aim to keep inflation at about 2% and support robust labor markets.
U.S. unemployment at 4.3% is not high, but one-quarter of jobless Americans have been seeking positions for more than six months.
Many white collar workers displaced by Artificial Intelligence may never work again in the kinds of good pay jobs they just recently enjoyed and must accept lower pay or retrain for blue-collar careers.
Simply, the economy has more college graduates with degrees in business, the social sciences and humanities than it can absorb.
Most recently, when the economy was similarly challenged—the 2008 Global Financial Crisis and COVID recession—western governments responded with excessive borrowing to support financial institutions and households.
Central banks purchased considerable portions of this debt and expanded their balance sheets—so called Quantitative Easing.
Warsh sees this as excessively increasing the Fed’s footprint in the economy and something that should be reversed.
Perhaps not repeated, but those episodes can’t be reversed.
In the current drama, the Fed would be neutral by just standing pat.
Since peaking at $8.9 trillion in April 2022, it has worked down its balance sheet to $6.6 trillion.
Just prior to the GFC, the federal budget was nearly balanced—in 2007, the deficit was 1.2% of GDP. But by the end of Barack Obama’s presidency, new spending initiatives like the Affordable Care Act took it to 2.9% of GDP.
The Fed’s balance sheet expanded radically to bail out banks and households during the GFC, but it didn’t enable those permanently larger federal deficits.
The latter half of the 2010s, the Fed’s balance sheet remained flat at about $4 trillion then shrank.
Domestic and international bond investors financed permanently larger federal deficits, not the Fed by running the printing press.
President Trump’s first term tax cuts and President Biden’s industrial policies further increased the federal deficit to about 6% of GDP depending on how much of the Trump tariffs the Supreme Court lets stand.
Although the Fed initially enabled the Biden industrial policies by expanding its balance sheet, since it got serious about inflation, monetary policy hasn’t been loose.
Its balance sheet, which stood at $8.9 trillion in April 2022, is now $6.6 trillion.
That’s why as it has lowered the bank overnight borrowing or federal funds rate to 1.75%, the 10-year treasury rate, which critically influences mortgage and business borrowing costs, has increased about 0.4%.
If the Fed significantly reduced its balance sheet further, the federal government would have to dramatically reduce its budget deficit. Simply, the Treasury would face too much competition in international credit markets for the limited supply of global savings and the bonds the Fed would be selling.
The EU is borrowing up to $1 trillion to rebuild its militaries to cope with receding U.S. security guarantees and Russia’s revanchist designs on Eastern Europe.
Japan’s new prime minister, Sanae Takaichi, is committed to altering Japan’s constitution to permit rearmament, new civilian investments and borrowing to finance those.
The UK is looking to partner with private capital to rearm.
American hyperscalers — Amazon, Alphabet, Microsoft and Meta — are committed to doubling their capital spending from 2024 levels, largely for AI data centers and supporting infrastructure, to sums equaling about 2% of GDP.
That’s a massive new stimulus program financed by just four private firms. Their revenues alone can’t fund it, and they are selling bonds in international capital markets on the scale of middle-sized advanced economy governments.
By 2032, Social Security trust fund that finances old age pensions will be empty. Congress must preside over a 24% reduction in benefits, substantially tax increases or further increase borrowing — credit markets likely balk at the latter.
It’s not up to the Fed or any other central bank to solve any or all of this. But the Fed by selling off a few trillion dollars from its balance sheet would shatter global capital markets, and send longer-term interest rates, like the 10-year treasury rate, rocketing.
Mr. Warsh may accede to President Trump’s demands for lower interest rates by lowering the federal funds rate, but he can’t deliver a lower 10-treasury rate without running the printing press to buy longer-term government bonds.
Ruinous inflation would follow.
Instead, we are about to witness a massive reallocation of global savings to support rearming the West, the AI transformation and an aging population
The Fed will be challenged to simply stand on the sidelines and let markets and politics do their work.
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Peter Morici is an economist and emeritus business professor at the University of Maryland, and a national columnist.
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