What does Warsh want?

Jerome Powell's term as Fed chairman formally ends in mid-May, and markets have turned their full attention to Kevin Warsh, who takes over. Modelling desks and bond traders reckon this is the biggest break in the Fed's leadership since Paul Volcker took office in 1979.

Why the models may break

For quantitative desks the difficulty is statistical. Most models of Fed behaviour, from simple Taylor rules to the reaction functions embedded in yield-curve models, are fitted to decades of data from chairmen who shared a broadly similar playbook. A chairman with a different view of the balance sheet changes the relationship being estimated, the problem Robert Lucas set out in his 1976 critique of econometric policy evaluation: parameters fitted under one regime cannot be trusted under the next. The Volcker precedent is sobering. Within two months of taking office he switched the Fed to targeting bank reserves, and short-term rates later touched 20 per cent.

The practical response on modelling desks is to shorten memory. Reaction functions estimated over thirty years give heavy weight to chairmen who are no longer in charge, so desks will lean on rolling windows, regime-switching models that allow parameters to jump, and above all on prices quoted in the market today. Futures and options embed traders' current guesses about the new chairman directly, which makes them more useful than any coefficient fitted to the Greenspan or Bernanke years, though noisier.

How Warsh would set policy

Warsh's academic papers and speeches set out a bold and unconventional doctrine. He sees the Fed's $6.5 trillion balance sheet as a dangerous tool of fiscal dominance, far from a harmless source of liquidity. In his view it distorts asset prices, sends capital to the wrong places and helps Congress run deficits without restraint. His main aim is plain enough. He wants to shrink the Fed's holdings quickly and, in exchange, cut the benchmark policy rate.

The doctrine runs through his career. He sat on the Board through the financial crisis, voiced doubts about the second round of bond buying before leaving in 2011, and has since made the same case from Stanford's Hoover Institution. What sets him apart from other critics of quantitative easing is the trade he proposes: less balance sheet in return for a lower policy rate, which in principle leaves overall financial conditions no tighter.

Guidance loses its weight

Communication is the second channel through which the break could show. Since 2012 the Fed has published its officials' individual rate projections, the so-called dot plot, and under Powell it paired them with a press conference after every meeting. Models that read the expected path of rates from those signals depend on the chairman treating them as commitments. A chairman who talks less about the future, or treats the projections as a committee's musings rather than a plan, removes an input that desks have used for more than a decade, and rate volatility would rise to fill the gap.

Cheaper overnight, dearer long-term

Bond markets would reprice along the whole yield curve. Short-term rates would come down to support productivity and hiring. Long-dated Treasuries would lose the prop of Fed reinvestment, and term premia would probably rise sharply.

The mechanics run through the Treasury market. When the Fed lets a bond mature without replacing it, the Treasury must refinance that debt with someone else, so every dollar of run-off becomes a dollar of extra private supply on top of the deficit. Pension funds, insurers, foreign official buyers and leveraged funds would take it on, and they demand compensation for holding duration. Since December the Fed has been rolling its maturing mortgage securities into Treasury bills, so the first practical step towards a smaller portfolio might simply be to stop that reinvestment.

Term premia cannot be observed directly, which complicates the call. The New York Fed publishes model-based estimates that split the ten-year yield into expected short rates and a residual premium, and those estimates will be the quant desks' main gauge of whether a Warsh balance-sheet plan is being priced. A rise in the premium with little change in expected short rates would be the signature of the trade he has described.

Winners and losers on the curve

A steeper curve helps banks, which fund themselves at the short end and lend at the long end. The losers would be holders of long-dated bonds and borrowers whose costs follow long yields: American mortgage rates track the ten-year Treasury closely, and a shrinking Fed portfolio of mortgage securities removes a steady buyer from that market. The government itself would pay more on new long-term borrowing, which is presumably part of the discipline Warsh has in mind.

Savers at the short end lose as well. Households and companies moved large sums into money-market funds once rates rose, and a lower policy rate cuts their income within weeks, since those funds hold paper that matures quickly. Borrowers on floating rates, from leveraged companies to credit-card holders, gain at the same speed.

Limits on a new chairman

The strongest argument against a sharp break is institutional. The chairman is one vote on a committee that decided in 2019 to run policy with ample reserves, and banks now hold reserves partly to satisfy liquidity rules written after 2008, so the floor under the balance sheet is set by regulation as much as by preference. Shrinking it much further would mean changing those rules or the Fed's operating framework, and both take time. A lasting change would also need the Treasury's co-operation on how much long-dated debt it issues. The last formal settlement between the two, the accord of 1951, went the other way, freeing the Fed from pegging bond yields for the Treasury.

Traders will look for early signals in the minutes of his first meetings, in any cap on the monthly pace of run-off, and in the options market's pricing of rate volatility. Warsh wants to unwind the central banking settled on after 2008, and if he gets his way, cheaper overnight money will come with a flood of Treasury supply that private buyers must absorb at higher long-term yields.