Powell leaves, Warsh enters: find out what the new head of the Federal Reserve will inherit

As Fed chairman, a role he will soon assume, Kevin Warsh will need to navigate a delicate economic moment, a president demanding lower interest rates and an increasingly divided leadership committee — whose members will now include Jerome Powell, the outgoing Fed chairman.

It is the first time since 1948 that a former Fed chairman will remain at the central bank after his term ends. Jerome Powell’s decision to remain a member of the Board of Governors reflects his concerns about the Fed’s independence amid the Trump administration’s demands for lower interest rates.

The Justice Department investigated Powell and the Fed over renovations at its headquarters, a move that was widely seen as a pretext to exert pressure. Last month, the department closed the investigation but said it could reopen it at any time.

President Donald Trump is also trying to remove Lisa Cook, a governor appointed by Biden. Whether he has the legitimacy to do so is now under review by the Supreme Court.

Powell’s stay means Trump may not have the opportunity to nominate another governor to the seven-member board until January 2028, when Powell’s term as governor expires.

Also read: Inflation far from target and independent Fed: what is Jerome Powell’s legacy?

Interest rate pressures

A crucial question for Warsh as he begins his term as president is whether he will comply with Trump’s wishes as the president’s nominee — something Warsh has repeatedly denied.

Trump has expressed a desire for rates to drop to 1% or even lower to stimulate economic growth. At its April meeting, the Fed kept the federal funds rate, its benchmark interest rate, in a range of 3.5% to 3.75%.

The Fed uses its benchmark interest rate to direct the economy with two main goals: keeping inflation levels low and the job market stable and healthy.

During a period of runaway inflation in the 1980s, then-president Paul Volcker pressured the Fed to raise interest rates to double digits to slow rising prices. The efforts worked, but at the cost of two recessions.

Powell, who also faced inflationary challenges as Fed chairman, frequently referenced the Volcker era. During the post-Covid-19 recovery period, inflation reached its highest level in decades. After initially erroneously arguing that higher prices were likely to be “transitory” and that raising interest rates was not necessary, Powell and his colleagues were forced to change course. They have raised interest rates from near zero in 2022 to as high as 5.5% in July 2023.

Since the start of the war in Iran, rising energy prices have driven prices up again, and some Fed members believe lowering rates will lead to a resurgence in inflation. At the same time, the job market has remained relatively solid, further weakening the case for cuts as a way to reduce borrowing costs and stimulate growth.

If the Volcker era was a guide for Powell, Warsh may be looking for parallels with another moment in the Fed’s history: the personal computing revolution of the 1990s.

Alan Greenspan, then chairman of the Fed, resisted the call to raise interest rates at a time when many feared the economy was overheating. He argued that the United States was experiencing a productivity boom, which meant that strong growth was unlikely to be accompanied by inflation, an intuition that proved correct.

Warsh said he believes the country is on the cusp of a similar productivity boom today, driven by artificial intelligence. If this is confirmed, it could pave the way for the Fed to reduce interest rates without fueling inflation.

A balance sheet of US$6.7 trillion

Interest rates are the most visible aspect of the Fed’s efforts to direct the economy. But the central bank also plays another fundamental role: that of investor.

It regularly buys government bonds, mortgage-backed securities and other assets. These assets are balanced by the Fed’s so-called liabilities, that is, the debt it owes to third parties. These assets mainly include the paper money that comes in and out of circulation and the deposits it maintains for banks, also called “reserves”.

In periods of economic crisis, the Fed often increases its investments considerably. At the height of the 2008 financial crisis, it bought huge amounts of Treasury bonds and mortgage-backed securities to help lower long-term interest rates — part of a policy known as “quantitative easing” aimed at keeping credit affordable throughout the economy.

Warsh, who at the time was one of the Fed governors, initially supported the initiative. But he spoke out on policy, arguing that the Fed was distorting financial markets. Resigned in protest in 2011.

The central bank’s balance sheet has expanded considerably since then as a result of another wave of quantitative easing during the pandemic.

Reducing the more than $6 trillion in assets on the Fed’s balance sheet is now a priority for Warsh. But there are internal disagreements about whether and how to do so.

A new era of internal divisions

During his confirmation hearing on how he would run the Fed, Warsh said he preferred “more boisterous meetings” and “a good family discussion.”

Your wish may be about to come true. Decades of little or no formal disagreement among top Fed officials ended during the Powell era.

An interest rate decision requires the agreement of a majority of the 12 voting members of the Fed’s rate-setting committee, made up of the seven-member Board of Governors and a rotating group of five presidents of the Federal Reserve’s regional banks. Historically, presidents have dissented more frequently than members of the Board of Governors, whose objections have been rare. Powell’s term was marked by dissent on both sides, and in opposite directions.

At Powell’s last meeting as chairman in April, there were four dissenting votes, the most since 1992, when the Fed decided to keep rates unchanged. Three regional presidents supported the decision to keep rates stable, but wanted the Fed to signal that the next step would not necessarily be a cut. (Stephen Miran, the outgoing Trump-appointed governor, voted in favor of an interest rate cut.)

This public disagreement among Fed officials, especially governors, could fuel fears that the central bank lacks conviction in its monetary policy decisions.

Powell’s decision to remain on the board is another unknown. He has said he has no intention of undermining Warsh’s authority, but his presence alone will certainly carry great weight at the Fed, and his vote could even be decisive if dissent persists within its ranks.