By Howard Schneider
WASHINGTON, Feb 5 (Reuters) – In the 15 years since leaving the Federal Reserve, Kevin Warsh has lectured often that the ideal central bank is one with the smallest possible footprint in the economy, focused intently on controlling inflation, and bound in part by policy rules rather than letting officials act as free-ranging “overlords.”
But President Donald Trump’s nominee to run the Fed also has acknowledged the messy realities of steering a complex economy, called policy rules “aspirational,” said shrinking the U.S. central bank’s balance sheet would be difficult, and, of late, offered reasons like productivity growth to justify lowering interest rates, as the president wants, even with inflation above the Fed’s 2% target.
The question now is which version of Warsh shows up after years of sideline criticism: The idealist who anchors his thinking in lessons learned about monetarism from the late Milton Friedman and about policy rules from economist John Taylor during Warsh’s undergraduate studies at Stanford University, or the pragmatist former Fed governor who helped shape the crisis-era bond purchases he later came to dislike?
From his affiliation with Taylor and Stanford’s Hoover Institution, a center of the camp of limited central banking, Warsh “talks the language” of curbing the Fed’s presence in financial markets and using rules Taylor pioneered to guide rate decisions, but always from a practical standpoint, said Michael Bordo, a professor emeritus at Rutgers University and distinguished visiting fellow at the Hoover Institution.
“I would see him as following some kind of rules-based policy. … But he is very pragmatic. He understands markets. He understands politics. He would be flexible. Rules with discretion,” Bordo said. “He is not going to be hidebound to anything.”
Warsh, 55, will be questioned about his approach in U.S. Senate confirmation hearings that will be scheduled sometime before May 22, when Fed Chair Jerome Powell’s term as central bank chief ends.
RULES ARE ‘ASPIRATIONAL’
There will be much to unpack.
In research he has done on Fed policymakers, for example, Bordo said Warsh rates as hawkish on inflation. At the same time, common “Taylor rule” iterations indicate the Fed’s current 3.50%-3.75% policy rate is about right, with little reason to cut further.
To argue that interest rates could still fall, Warsh, if he’s true to his past, would need to explain why the rules should be set aside, with his bet on a productivity surge being one possible rationale.
In a lecture at the Hoover Institution last May, Warsh said central bankers needed limits, arguing “the economy cannot thrive … with a fully discretionary central bank and central bankers acting as overlords.” Yet in the same speech he described the rules for limiting that discretion as “aspirational … it’s not E equals mc squared.”
John Cochrane, another colleague at the Hoover Institution, said one way to resolve the tension is for policymakers to set the rules they think should apply, but explain when they deviate from them.
“You start with the rule and then say why you want to do something different,” Cochrane said. “If you want to move in a more rule-like direction, that is the way.”
‘BRING CHRISTMAS EARLY?’
Warsh has never been far from the monetary policy debate since leaving the Fed in 2011, with the Hoover Institution as his base. With social ties to Trump, Warsh was nearly named Fed chief during the Republican president’s first term and will now provide an experiment in how the ideas developed over the past 15 years hold up in practice.
“Kevin has always been talking at a very high level of altitude about these things,” said Michael Strain, director of economic policy studies at the American Enterprise Institute. For example, he said, Warsh may move to reduce the Fed’s balance sheet, but “I don’t think we have a super-good sense of how much or over what period.”
For those believing the Fed has become too expansive, whether in its bond holdings or role in society, Warsh’s nomination is something of a moment of truth.
“Is he going to bring Christmas early?” said David Beckworth, a senior research fellow at George Mason University’s Mercatus Center. Beckworth has advocated his own policy rule variations and detailed ideas about how the Fed could reduce its roughly $6 trillion in Treasury bonds and mortgage-backed securities.
“It is hard to undo the current system. It will be interesting to see if he can do that,” Beckworth said. “There is a path forward, but it is a long one, step by step.”
‘BUILD UP THE TRUST’
Warsh said last May that if the Fed’s balance sheet had grown in the same way as the economy since he was a governor, it would be around $3 trillion today. It is more than twice that and growing again thanks to demand by banks for reserves held at the central bank.
Beckworth and others have laid out ways to let the Fed’s balance sheet shrink by curbing demand for reserves.
Warsh has said he has no illusions about how fast change might happen, particularly given that the Fed now uses its balance sheet to manage its targeted policy rate.
A different rate-management system “will take time,” Warsh said last May. “It is not something that could or should be done overnight.”
Still, he said, banks could shift to a new “liquidity regime” if guided by policymakers.
Warsh’s colleagues will need persuading, with some policymakers dismissive of the idea that a large Fed balance sheet is in itself a problem or leads to distortions in markets.
Other challenges may come from the massive federal deficit, the growing bond issuance needed to finance it, and the potential for that problem to clash with Trump’s desire to lower rates on long-term government debt and home mortgages.
Jeffrey Roach, chief economist at LPL Financial, said Warsh’s “less-interventionist” approach may also imply higher rates, and the best thing he can do to temper that is to reassure markets about his independence from Trump and commitment to controlling inflation.
“What he needs to do is convince global investors that there is independence, stability, build up the trust,” Roach said. “If you can convince global investors that U.S. Treasuries are still the best global risk-free option, that is going to help protect any upward drift in rates.”
(Reporting by Howard Schneider;Editing by Dan Burns and Paul Simao)
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