The transition of power at the Federal Reserve Tempest in a teapot?

Fed transition worries look like a tempest in a teapot as institutional resilience holds and geopolitics shape policy.

The congressional stars appear to be aligning for Kevin Warsh to be confirmed as the next Fed chair by May 15, when Jerome Powell’s term as chair ends. We expect Powell to step down from the Board of Governors as well, despite his term running through early 2028. Separately, we expect Governor Stephen Miran to be renominated for a full term and to remain on the Federal Open Market Committee (FOMC). What are the implications of these permutations?

Reinvigorated institutional resilience

Simmering worries about the erosion of Fed’s independence amid perceived political pressure to lower interest rates have been a recurrent theme in client conversations over the past year. We have repeatedly argued (last September and again in January) that these concerns were overblown given systemic guardrails and institutional resilience that favor policy continuity.

That view has been reinforced by recent developments. The end of the Department of Justice’s investigation into Fed renovation cost overruns strikes us as (perhaps forced) recognition on the part of the administration that overly aggressive tactics can backfire—not unlike what has transpired with immigration enforcement.

The broader and encouraging message here is that the system overall is more stable and resilient than what appears on the surface. While investors are right to worry about the potential erosion of that stability, overreacting to those concerns is unwise.

Iran war a much bigger near-term policy driver

Ever since Kevin Warsh’s nomination, we argued that his ascension to the Fed Chairmanship would have no discernable impact on the Fed’s reaction function. Since then, the Iran war has emerged as a far greater driver of near-term policy direction, both in our assessment and that of the FOMC.

At the start of the year, we expected three rate cuts beginning mid-year. We’ve since reduced those expectations to just two—in September and December. The median March “dot” still indicated one rate cut this year, as it did in January. But the overall tilt of the committee’s assessment has turned more cautious.

Governor Christopher Waller had previously leaned dovish but has recently signaled a willingness to delay further rate reductions while awaiting more clarity on both inflation and the labor market. Governor Miran had consistently favored outsized rate cuts in prior meetings but has also recently scaled back his rate-cut preferences. Meanwhile, more hawkish members of the committee could well deliver dissents favoring rate hikes at upcoming meetings.

Hence, the first order of business for Warsh will be to establish common ground for the committee as a whole. In practice, this likely means holding policy steady for some months. We believe the same would have been true under a Powell leadership as well.

The value of Fed’s independence and the “illusion of precision”

Kevin Warsh’s opening statement at the senate hearing included the following:

These statements do not strike us as unduly dovish or unduly controversial. Neither are we too concerned about his stated preference for trimmed-mean measures of inflation as a superior signal for monetary policy. The element that appeals the most is the implicit recognition that each data set is only a partial representation of reality and that the broader the field of information inputs, the more nuanced a picture of the economy they can paint.

Assessing traditional inflation measures alongside alternative ones improves the accuracy of interpretation. We also sympathize with his warning against what we would call “false precision” in the conduct of monetary policy; restoring credibility is not about “tenths of a percentage point” but about “durable price stability”. We agree and would in fact expand the warning to the broader interpretation of macro data—the “illusion of precision” in macro analysis is a real and present danger in a world of deteriorating data quality.

Balance sheet changes could be more about composition than size

Any actions meant to return the Fed to its “statutory remit” are likely to play out more via balance sheet policy than interest rate policy. However, we see those changes playing out more in terms of the composition of the Fed balance sheet (types of assets held, duration) and closer coordination with the Treasury than via a dramatic reduction in the size of the balance sheet per se.

While in nominal terms the Fed balance sheet is about 50% larger today than the prior pre-Covid peak, as a share of GDP it is about 4 percentage points smaller (Figure 1). There is room for some further reductions, but given the increase in cash in circulation as a share of GDP, the increase in average balances in the treasury general account, and the rise in bank reserves at the Fed—all of which are structural changes relative to the pre-GFC period—there is only limited scope for shrinking the balance sheet materially, at least in the short term. 

In summary

We do not expect to see any notable change in the FOMC reaction function because of leadership changes, while any changes to balance sheet policy will be gradual and limited.