The debate since President Trump nominated Kevin Warsh as his next Fed Chair has centered on whether Mr. Warsh will line up with the administration’s call for lower rates. That would be easy enough. The larger question is what magic he’ll have to cut policy rates while simultaneously shrinking the Fed’s massive holdings of Treasuries–and how he’ll do both without market mayhem that threatens the Fed’s self-mandated “financial stability”?
Businesses and households care less about the Fed’s policy rate for overnight loans. They want to know how much “term premium” they’re required above the policy rate to borrow for longer. Bond markets set that price, not the Fed—unless they want to keep yields artificially low buy buying the bonds themselves. That’s the lazy solution that has been used for the past 17 years, exploding the Fed’s balance sheet holdings from $800 billion to almost $9 trillion between the ’08 financial crisis and COVID, and it’s still $6.6 trillion today after inflation-induced “tightening”.
Having followed Kevin Warsh’s thinking for years, I believe he makes a solid case for reducing the Fed’s holdings and letting private markets price duration risk. He resigned from the Fed Board in 2011 precisely because he opposed the continuation of quantitative easing—the policy of Fed buying long-dated Treasuries and mortgage-backed securities to suppress yields. He argued then, and has repeated since, that QE created a dangerous dependency: financial markets addicted to central bank liquidity, lawmakers enabled to pile on debt without consequence, and a misallocation of capital that planted seeds for future instability. “My overriding concern about continued QE,” Warsh said in 2018, “involves the misallocations of capital in the economy and the misallocation of responsibility in our government.”
The Treasury was wise to refinance as much and as long duration as possible for before being forced by transitional inflation to raise policy rates in 2022. The weighted average maturity of marketable Treasury debt declined to just 49 months during the 2008 crisis as Treasury scrambled to raise cash through short-term bills. By 2025, average maturities had maturities had stretched back out to 71 months.
Warsh’s problem will be what happens as the current $4.2 trillion of Treasury securities still held on the Fed balance sheet matures. If he lets the Fed’s holdings refinance in private markets, he can expect the clearing price for duration to be significantly higher than the Fed received on its balance sheet holdings in the lower interest rate environment. That will be a burden on the businesses and families, and an even larger budgetary burden for the Federal government already paying $1 trillion in interest in the national debt, more than defense and any single healthcare program.
This year’s refinancing calendar will be at least as aggressive as it was last year, when roughly $9 trillion of mostly short-term bills matured and were rolled over in short duration. Warsh will almost a much flexibility this year, as most near-term maturities are short-term bills that can be rolled forward again. If he is right about the disinflationary efficiency gains of AI and other technologies, there may even be room for lower policy rates, yielding interest savings.
Warsh’s first test will be how the Fed handles the roughly $500 billion of seven-to-ten-year duration Treasuries maturing in the next year. If the Fed follows Warsh’s principles and allows long-dated Fed holdings to mature without reinvestment, private markets must absorb that duration. Don’t be surprised if markets demand more than 4.3% to hold U.S. sovereign credit for up to ten years in the present fiscal environment.
The trilemma
Kevin Warsh faces a trilemma over the horizon. He can shrink the balance sheet and accept higher long-term yields—which works against the administration’s stated goal of reducing borrowing costs and could destabilize a housing market already frozen by 7% mortgage rates. He can maintain the Fed’s holdings at lower yields, perpetuating the “monetary dominance” he has long criticized. Or he can pursue the go-to can-kicking option: rolling maturing securities into shorter duration, effectively converting the Fed’s portfolio into a de facto floating-rate liability while deferring the private sector’s absorption of term risk.
Which option is least bad? The first option risks a private market repricing of risk assets leading to potential recession. The second abandons the intellectual framework that apparently motivated Warsh’s interest in the position. The third might buy time but at the cost of leaving the market undersupplied with term credit, and with the fundamental fiscal problem still worsening as deficits compound and debt service consumes an ever-larger share of federal outlays. The Fed will have a couple of years to work with before the COVID-era longer duration bonds mature.
Where is Paul Ryan when we need him? He was the last fiscally responsible Republican leader, who declared in 2012 that “a defining responsibility of government is to steer our nation clear of a debt crisis while there is still time”. That time has grown shorter. Warsh understands the stakes better than most.
Bill Gross’ “cleanest dirty shirt” in the global monetary system is becoming harder for everyone to wear. Whether Kevin Warsh can navigate a graceful exit from the Fed’s extraordinary interventions—or whether markets will impose their own solution would be the defining question of his tenure.
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