Kevin Warsh’s Poisoned Chalice – Inside Sources

The Economist ran a memorable front-page cover in 2006 when Ben Bernanke replaced Alan Greenspan as Federal Reserve Chairman. It had Bernanke and Greenspan in a relay race. Instead of having Greenspan pass Bernanke a baton, it had him passing Bernanke a stick of dynamite. The Economist was alluding to the housing and credit market bubble that Bernanke was inheriting. The bursting of that bubble led to the 2008-2009 Great Economic Recession.

In May, subject to Senate confirmation, Kevin Warsh is set to replace Jerome Powell as the Fed’s chairman. We have to wonder whether The Economist might not run a cover similar to that of 2026, but this time with Powell passing Warsh not one but three dynamite sticks. Those sticks might allude to the country’s public finance mess, the Iran war-induced energy crisis, and the severe strains in the country’s credit markets.

Start with the very poor state of our public finances. According to the Congressional Budget Office, our government is set to run budget deficits of at least $2 trillion, or 6 percent of GDP, annually for as long as the eye can see. That, in turn, will soon take our public debt relative to income to its highest level since the end of World War II.

Managing monetary policy with our public finances on an unsustainable path will put Warsh in an unenviable position of having to choose his poison. If he is forced to raise interest rates to keep inflation under control, he risks incurring President Trump’s wrath and risks exacerbating an already bad budget situation by raising the government’s interest payment bill. If, on the other hand, he keeps interest rates low to avoid harming public finances, he risks accelerating inflation. In turn, that could lead foreign investors to believe that our government will try to inflate itself out of its debt mountain.

With foreign investors owning $8.5 trillion, or around 30 percent of all U.S. Treasury bonds outstanding, the last thing Warsh can afford is to have them lose confidence in us as a reliable debtor nation. Should they, for any reason, balk at financing our gaping budget deficits, we could find ourselves well on the way to a bond market and dollar market crisis.

No central bank head wants to be in a position where the two parts of the Fed’s dual mandate — price stability and maximum employment — are in conflict as far as interest rate policy is concerned. Yet, that is where Warsh might find himself on day one when he takes office. 

The energy crisis precipitated by the Iranian war might be exerting considerable inflationary pressure by causing a spike in gasoline prices at the pump. That would mean inflation would be drifting away from the Fed’s 2 percent inflation target. That might call for a hike in interest rates. 

At the same time, the Artificial Intelligence revolution might begin having a real effect on an already weak labor market, thereby raising unemployment well above its current 4.4 percent level. That would make a case for the Fed to cut interest rates.

Even worse, Warsh might soon find himself in the unenviable position of having to deal with the bursting of a variety of credit market bubbles. As Jaime Dimon, the head of JP Morgan, keeps reminding us, years of ultra-easy money have created irresponsible lending and the unhealthy build-up of leverage in the economy. This is especially the case in private credit, commercial real estate, and credit derivatives. Like Bernanke before him, Warsh might find that these bubbles burst on his watch when the era of easy money comes to an end.

With all of these challenges, if ever there was a time for Fed independence, it is now, when it is essential that market confidence be maintained that we are not on the road to higher inflation. The best thing Trump can do for Warsh is to refrain from continuing his relentless attacks on the Fed’s independence.