Warsh: rate hikes, not balance sheet or AI, are Fed's best route to 2% inflation
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Federal Reserve Chair Kevin Warsh views interest-rate hikes as by far the best chance of returning inflation to the Fed's 2% target, despite their unpopularity. Shrinking the balance sheet and relying on an AI-fueled productivity boom are poor substitutes, with transmission effects that take even longer, if they exist at all. The Fed has already cut its balance sheet from $9 trillion in April 2022 to $6.6 trillion, yet inflation has stayed above target for more than five years.
Key Facts
- Warsh has backing on the 19-member Federal Open Market Committee to reduce the balance sheet as a way to shrink the Fed's footprint, but not as the primary tool to tackle inflation.
- The Fed's balance sheet has fallen to 28% of GDP from a peak above 40% in 2022, after shrinking to $6.6 trillion from $9 trillion in April 2022.
- Fed Governor Christopher Waller puts the transmission lag for monetary policy at closer to nine to 12 months, down from a traditional 12 to 24 months.
- The Fed is buying Treasury bills to guard against a liquidity shortage and a spike in money-market rates as it shrinks its balance sheet.
- Treasury Secretary Scott Bessent also wants a smaller Fed balance sheet.
Rate Hikes Versus Alternatives
Federal Reserve Chair Kevin Warsh has indicated there are several routes for returning inflation to target, but the one with by far the best chance of succeeding is raising interest rates. Draining excess liquidity by shrinking the Fed's balance sheet and relying on an AI-fueled productivity boom are the alternatives Warsh has nodded to. If the goal is to meet the price stability half of the Fed's mandate and to signal that slaying inflation is the priority, those alternatives are poor substitutes for rate hikes. Recent economic indicators have given the Fed unexpected breathing room, but Warsh will be under heavier pressure to act if inflation remains elevated above 2%. Balance sheets and productivity won't cut it.
The Fed's Shrinking Balance Sheet
The Fed has substantially reduced its balance sheet from the post-pandemic peak, yet inflation has still been above target for more than five years. The central bank shrank its balance sheet by more than a quarter, to $6.6 trillion at the end of last year, from $9 trillion in April 2022. As a share of GDP, the balance sheet has been cut to 28% from a peak of more than 40% in 2022. Further quantitative tightening risks reducing bank reserves and liquidity in the system to worryingly low levels and prompting a dangerous spike in money market rates.
Treasury Bill Purchases
The Fed is gradually expanding its balance sheet again by buying Treasury bills precisely to guard against a liquidity shortage and to ensure sufficient liquidity in a growing economy. Warsh has backing on the 19-member Federal Open Market Committee to reduce the balance sheet as a way to shrink the Fed's footprint in financial markets, but not as the primary tool to tackle inflation. If the Fed is simultaneously buying T-bills, getting the public and markets on board with a reverse Operation Twist would be a challenge. Treasury Secretary Scott Bessent also wants a smaller Fed balance sheet.
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Warsh: rate hikes, not balance sheet or AI, are Fed's best route to 2% inflation
