Powell's final meeting

Jerome Powell chaired his last meeting of the Federal Open Market Committee on 28 April, closing an eight-year term that took in a pandemic, the worst inflation in decades and a run of trade wars. His chosen successor, Kevin Warsh, arrives with plans that make government bond traders nervous.

What Powell leaves behind

Powell steered the Fed through the most violent inflation in forty years without a balance-sheet collapse, which is more than many expected. He leaves a divided committee. Policy rates are on hold at 3.50–3.75 per cent, core services inflation will not come down, and an energy crisis in the Middle East shows no sign of containment. A chairman who worked by consensus is about to be replaced by one with firmer views and no record in the job.

The record is mixed in the usual way. The Fed cut rates to zero in March 2020 and bought bonds on a scale that took its balance sheet to nearly $9 trillion. It was then slow to accept that inflation was more than transitory, and had to lift rates from near zero to 5.25-5.50 per cent between March 2022 and July 2023, including four consecutive increases of three-quarters of a point. Unemployment rose far less during the disinflation than many economists had predicted, and that credibility is the main asset his successor inherits.

He also changed how the Fed talks. Powell began holding a press conference after every meeting in 2019, which made each gathering a live event and tied the committee to explaining itself eight times a year. Markets have come to treat those sessions as the main source of guidance. A new chairman who uses them differently, or speaks more bluntly, will move prices through that channel before he moves a single rate.

A committee without an anchor

The divisions show in the votes. The rate cuts at the end of last year drew dissents from both directions, with some members wanting faster easing and others wanting none. Powell held that coalition together by moving slowly and explaining a great deal. Warsh will have one vote of twelve and must build his own majority, which is harder when the data point different ways at once: sticky services prices argue for holding, while an oil shock that squeezes real incomes argues for easing.

Powell's own position adds an oddity. His term as chairman ends in May, but his separate term as a governor runs until early 2028, and nothing obliges him to leave the board with the chair. Departing chairmen usually do go. Marriner Eccles was the notable exception, staying on as a governor after he lost the chair in 1948. A former chairman sitting at the table would be one more reason for Warsh to move carefully.

Warsh wants a smaller balance sheet

Bond desks are preparing for a change of approach. Warsh has said he would shrink the Fed's $6.5 trillion balance sheet in return for lower policy rates. That would leave private buyers to absorb far more government debt, and fairly soon.

His views are long held. He sat on the Board of Governors from 2006 to 2011, through the financial crisis, and has criticised large-scale bond buying for most of the years since. The logic of his trade is that a smaller portfolio withdraws support from long-dated bonds, while lower short rates offset the tightening at the front end. In market terms it is a bet on a steeper yield curve. Banks, which borrow short and lend long, would welcome that; holders of long bonds, and mortgage borrowers whose rates track long yields, would not.

The mechanics cut through reserves. When the Fed lets a bond mature without replacing it, the Treasury must sell a new one to a private buyer, and that buyer's payment drains reserves from the banking system. Shrinking the portfolio therefore shrinks reserves too, and does so at a time when the Treasury is already selling extra debt to cover large deficits. The Fed's mortgage-backed securities add to the pressure: as they run off, private investors must hold more mortgage risk, and the spread between mortgage rates and Treasury yields tends to widen.

Lessons from the last run-offs

Two precedents counsel caution. In 2013 a mere hint from Ben Bernanke that bond purchases might slow sent ten-year yields up by more than a percentage point within four months. In 2019 the Fed stopped shrinking its holdings, and weeks later reserves proved scarce enough for overnight repo rates to spike, forcing it to start buying bills again. The Fed halted its most recent run-off only in December, citing the need to keep reserves ample, which suggests the floor under reserves is not far below where they sit now.

There is an older precedent for redrawing the line between the Fed and the Treasury. The Accord of 1951 freed the Fed from its wartime duty to cap government bond yields, and it took months of open conflict to agree. Any plan to hand more duration back to private markets raises the same question in reverse: how much of the Treasury's financing burden the central bank is willing to carry. The answer depends on the Treasury's co-operation as much as on the Fed.

Where the risk lands

The case for calm is that no chairman moves the balance sheet alone, and a committee that has spent years finding the level of reserves the banking system needs will not discard that work quickly. Any run-down would probably be announced well ahead and phased in. That argues against a rout, though not against a steady rise in the premium investors demand for holding long bonds. The signals to watch are Warsh's first press conference, the balance-sheet language in the statement after the June meeting, and whether the Treasury leans further towards bills to spare the long end. Bond investors lose a predictable chairman this week, and if Warsh starts running down the balance sheet as promised, long-dated Treasuries are likely to be choppier and cheaper within months.