Warsh, on the shortlist for Fed Chair, advocates for more QT, a smaller balance sheet, and lower short-term rates, in sync with Bessent.

By Wolf Richter for WOLF STREET.

Kevin Warsh, former Federal Reserve Governor and now on the shortlist of candidates to replace Powell as chairman of the Federal Reserve, came out with an editorial in the WSJ today that hammered away at the Fed’s current and former leadership – faulting them for years of QE and the large balance sheet that it produced, and advocating for a smaller balance sheet (more QT) and lower short-term interest rates.

He’d served as a member of the Federal Reserve Board of Governors from 2006 to 2011 under Ben Bernanke and supported QE-1 during the heat of the Financial Crisis, but opposed QE-2, and shortly after Bernanke pushed through QE-2 against all opposition, including from Warsh, he quit. He has been vocally opposed to the concept of “continued QE” and a large balance sheet ever since.

That’s his story, and he’s sticking to it (apologies to Collin Raye’s country song “That’s My Story”), including in today’s editorial in the WSJ, where he proposed four big changes of thinking at the Fed, one of which – his “second” point – dealt with the balance sheet and interest rates; he wants a smaller balance sheet and lower Fed policy rates:

“Second, inflation is a choice, and the Fed’s track record under Chairman Jerome Powell is one of unwise choices. The Fed should re-examine its great mistakes that led to the great inflation. It should abandon the dogma that inflation is caused when the economy grows too much and workers get paid too much.

“Inflation is caused when government spends too much and prints too much.

“Money on Wall Street is too easy, and credit on Main Street is too tight.

“The Fed’s bloated balance sheet, designed to support the biggest firms in a bygone crisis era, can be reduced significantly.

“That largesse can be redeployed in the form of lower interest rates to support households and small and medium-size businesses.”

Secretary of the Treasury Scott Bessent, who has been interviewing candidates for the job to run the Fed, including Warsh, has been making similar noises.

In an essay published by the WSJ in September, he blasted the Fed for its “extraordinary” and “nonstandard” monetary policies since 2008, such as QE; its “pursuit of the Wealth Effect”; its interventions that became a “de facto backstop for asset owners,” thereby concentrating “national wealth among those who already owned assets.” He skewered the Fed for having caused home prices to soar, while “younger and less affluent households, shut out of ownership and hit hardest by inflation, missed out on appreciation” (my discussion of Bessent’s essay).

So Bessent and Warsh are largely in sync on this topic.

Warsh, back in 2018, hammered at the problem of “continued QE,” and he seems to not have changed his mind since then:

“My overriding concern about continued QE, then and now, involves the misallocations of capital in the economy and the misallocation of responsibility in our government. Misallocations seldom operate under their own name. They choose other names to hide behind. They tend to linger for years in plain sight. Until they emerge with force at the most inauspicious of times and do unexpected harm to the economy.”

A “significantly” smaller balance sheet – continued QT – would likely mean slightly higher long-term interest rates, including higher mortgage rates. But long-term interest rates are predominantly driven by inflation fears and the onslaught of supply of government debt that markets have to absorb, compared to which the effect of QT may be relatively small. So if inflation gets worse and stays that way, amid mounting deficits, substantially higher long-term interest rates could be in the offing under this scenario.

Lower policy interest rates by the Fed would mean lower short-term interest rates. And they don’t determine long-term interest rates.

The combination of lower short-term interest rates and higher long-term interest rates would steepen the yield curve back into some kind of healthy position, after years being nearly flat or inverted. Higher long-term interest rates, including higher mortgage rates, could also have a dampening effect on inflation.

The fact that both Bessent and Warsh are speaking out against the Fed’s massive balance sheet and years of QE is very interesting.

Powell – architect of mega-QE during the pandemic, and of the “ample reserves regime” that is now keeping the balance sheet at the still inflated level though it has come down by $2.4 trillion – is on the way out as chairman.

The fact that Bessent put Warsh on the shortlist, even if Warsh doesn’t make it, could be a sign that a major balance-sheet rethink that has been circulating for a while is gaining momentum.

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WOLF STREET FEATURE: Daily Market Insights by Chris Vermeulen, Chief Investment Officer, TheTechnicalTraders.com.