Warsh’s views on Fed independence are met with confusion and concern

Most people don’t know what a currency swap line is, and there’s not much reason to care, except that this financial instrument could soon help the market understand what Federal Reserve Chairman candidate Kevin Warsh’s unique ideas about Fed independence actually mean.

Warsh asserted that the Fed should be “strictly independent” in making monetary policy decisions. But he added that he was ready to work with Congress and the Trump administration on “non-monetary issues.”

In response to questions from senators after his April 21 confirmation hearing, he elaborated that “Fed officials are not entitled to the same special deference, especially in areas that affect international finance.”

Mr. Warsh has also frequently talked about a new “Fed/Treasury Agreement,” which he has suggested could control the Fed’s balance sheet, but he has not yet provided details.

To the six former Fed officials interviewed for this article, these comments were unclear or confusing at best. When it came to the Fed’s independence, they found his analysis alarming at worst. The result could be benign, tinkering with existing conventions, or it could limit the Fed’s ability to leverage its balance sheet in times of crisis. Warsh’s comments lacked clarity, and none of the former officials who spoke to CNBC were ready to draw any conclusions one way or the other.

Former Richmond Fed President Jeffrey Lacker, a longtime hawk on interest rate and balance sheet policy, said he might welcome a new agreement between the Fed and Treasury if it focused on monetary policy and left credit policy to the Treasury. For example, under such an agreement, the Fed could be limited to buying government bonds rather than mortgages or other financial products.

But Rucker added, “I can also imagine less constructive agreements that would allow the Treasury to use the Fed’s balance sheet to circumvent Congress, perpetuate bad practices, and undermine the Fed’s independence.”

“Following its logical conclusion, the Fed could lose control of its balance sheet,” said one former senior Fed official, who spoke candidly on condition of anonymity.

Warsh’s views on what monetary policy is and is not are not entirely clear. He may elaborate more if confirmed by the Senate, but for now lawyers, economists and Fed observers are left to parse cryptic comments like his Senate response.

Warsh declined to comment for this article.

One challenge facing Fed observers is that the distinction between the central bank’s monetary and non-monetary functions is not always clear-cut.

Swap lines occupy that gray area, according to multiple former Fed officials. Primarily used during financial crises, the Fed gives dollars to other countries’ central banks and receives an equal amount of foreign bank currency in return. Fed officials say such a deal would provide dollar liquidity to foreign markets to prevent or reduce a scramble for dollars abroad that could impact U.S. markets.

Treasury Secretary Scott Bessent recently said several Persian Gulf countries, including the United Arab Emirates, have requested swap lines. The Treasury could provide these swap lines using Treasury’s own funds, as it recently did with Argentina. But what’s unclear is whether Mr. Bessent wants the Fed to provide them. In a written question, senators asked Mr. Warsh if he thought the Fed should follow the Treasury’s wishes, but Mr. Warsh did not answer directly.

For former Fed officials, swap lines can be thought of, at least in part, as monetary policy. The first clue is that it requires approval from the Federal Open Market Committee, which is responsible for determining monetary policy. Second, the supply of dollars to foreign central banks increases their balance sheets when swap lines are drawn. During the Great Financial Crisis, swap lines temporarily added nearly $600 billion to the Fed’s balance sheet, representing 25% of the Fed’s balance sheet at the time, according to Haver Analytics data. During the coronavirus pandemic, swap lines reached up to $450 billion.

Warsh’s comments may not result in an immediate change in policy. In fact, in moments of crisis, the Fed and Treasury work together to address market turmoil. That was the case when Mr. Warsh served as a Fed director during the 2007-2008 crisis. But the decision remains the Fed’s, and the rationale is almost always a systemically significant disruption to dollar liquidity.

“In the worst-case scenario, the Fed’s balance sheet becomes a branch of foreign aid,” said another former Fed official, who also spoke candidly on condition of anonymity.

That’s the potential danger lurking in swap lines in the UAE and other Gulf states. These countries don’t seem to need them to avoid a dollar liquidity crisis, so providing them may seem like a political decision rather than a question of whether markets need them to function.

Even if there is a liquidity problem in the Gulf, I don’t see the US having a dollar funding problem at this point. The UAE is a wealthy country with significant foreign exchange reserves and a sovereign wealth fund. At the same time, the administration has good reason to support its allies in the midst of the Iran war. Officials said a dollar swap line would give the UAE international status normally reserved for the G7 and other major developed countries.

Mr. Warsh also hinted at changes that could affect larger parts of the central bank’s operations. Mr. Warsh’s revised Treasury-Fed agreement, which has not yet been finalized, would somehow control the size and potential composition of the Fed’s balance sheet. This suggests that Mr. Warsh believes balance sheet policy is less essential to monetary policy than other Fed officials. Again, it’s unclear exactly what Warsh means by this agreement. However, decisions to buy or sell assets require the approval of a majority of the FOMC, indicating that this is ultimately a monetary policy decision.

Mr. Warsh and Mr. Bessent have criticized the Fed’s bloated balance sheet even outside of times of crisis. In fact, it was Mr. Warsh’s opposition to the Fed’s decision not to trim its balance sheet in the wake of the Great Recession that led to his resignation as governor in 2011.

Mr. Bessent likened the Fed’s expanding balance sheet to a dangerous laboratory experiment. He called this a “gain of capabilities,” saying it would increase the Fed’s influence in the economy and give it powers befitting the Treasury and the government.

Asked about Warsh’s thoughts on CNBC on April 14, Mr. Bessent said, “Especially during the global financial crisis, a lot of things have moved from the Treasury to the Fed, but that’s a political decision that should be made by the Treasury,” he said, “so we agree on that.”

But Mr. Bessent did not elaborate on exactly where he agreed with Mr. Warsh’s opinion. “I don’t know exactly what he wants to say about the Treasury/Fed agreement,” he said.

Mr. Rucker is one of the people who has criticized the Fed’s involvement in “credit policy,” which he defined as the Fed’s purchases of things other than government bonds. The Fed began buying mortgages during the Great Recession and has also moved into buying corporate bonds during the pandemic.

Mr. Warsh’s idea of ​​an agreement between the Treasury and the Fed could limit the Fed to buying government bonds only.

However, agreements between the Treasury and the Fed could limit the Fed’s ability to leverage its balance sheet, for example, if the agreement requires the Fed to obtain Treasury approval regarding asset purchases or the types of assets that can be purchased.

“The challenge is when we face a serious crisis and fiscal policy doesn’t respond quickly,” said former Boston Fed President Eric Rosengren. If the Fed agrees to limits on the size and composition of its balance sheet and requires permission to act, “the flexibility that monetary policy provides is hampered.”

Rosengren recalled that one of the reasons the Fed bought mortgages was that it risked becoming too big a player in certain parts of the Treasury market.

“When short-term interest rates are restrained by near-zero rates, most Fed officials view balance sheet policy as simply interest rate policy by other means,” Michael Feroli, JPMorgan’s chief U.S. economist, wrote in a note Friday.

A bigger concern for former Fed officials will be whether the Treasury Department can order the central bank to buy certain amounts or types of assets. This loss of independence could spook bond markets because the Fed could be seen as financing deficits or allocating credit to particular sectors favored by politicians. This is something the Fed has already been accused of doing through various asset purchases. This could be seen as the equivalent of the Treasury telling the Fed to ease policy.

Former St. Louis Fed President Jim Bullard said the idea of ​​the Fed and Treasury working together to limit what the Fed can buy has long been discussed. He agreed with Bessent’s criticism that the Fed accumulates assets in times of crisis and never actually reduces them. But Bessent’s other comments “sound like he’s talking about close cooperation, which usually has negative consequences,” he said.

Mr. Warsh’s views on the potential relationship between the Fed and Treasury may be more conventional. Although not without its critics, it is already common practice for the Fed to follow the administration’s lead on banking supervision policy. Under President Joe Biden, regulated banks have begun considering the financial costs of climate risk. It went down when President Donald Trump won re-election. However, it has since begun the process of reducing the regulatory burden on banks, in line with the government’s policy objectives.

The reason for this political change is that the Fed collaborates with other agencies led by political appointees to develop regulatory policy.

And when it comes to dollar policy, the Fed has long acknowledged that it is the purview of the Treasury Department.

JPMorgan notes that balance sheet reductions may gain some support at the FOMC, but it will take time.

“The other 11 members of the FOMC will act as a brake on the rapid shift in monetary policy under the Warsh administration,” Feroli said.

Mr. Warsh may believe that by pre-emptively relinquishing all other responsibilities, he can ensure the independence of the Fed’s core business of setting interest rates and ensure that it will never be questioned, even by the president who nominated him.

He hinted at that view during his nomination hearing. “The president wants to lower interest rates, but the Fed’s independence depends on the Fed,” Warsh said.