Kevin Warsh Wants to Change the Way the Fed Works. How Will That Impact the Stock Market?

There's a new man in charge at the Federal Reserve, and he wants to do things differently. That may have major consequences for investors.

Kevin Warsh assumed the top job at the Fed -- the Fed Chair -- just over a month ago, and he's already implementing changes at the world's most powerful central bank. Warsh has indicated three main things he wants the Fed to do differently.

Warsh wants less communication from the Fed to markets

Warsh's first priority is to change the way the Fed communicates. Essentially, he wants the Fed to communicate a lot less.

He's already implementing that policy. The most recent statement from the Fed's monetary policy committee, the Federal Open Market Committee (FOMC), was the first under Warsh's leadership. It ran just 131 words, about half the length of the previous meeting and the shortest statement since an emergency cut the Fed made during the COVID pandemic.

Image source: Getty Images.

The latest FOMC statement stripped out so-called "forward guidance," the language the Fed has historically used to give markets a sense of where it's heading on monetary policy. That's part of a larger shift Warsh wants to implement, in which all officials at the institution would provide much less forward guidance on where they think policy will go.

And while the Fed also releases a "dot plot" to show where members see interest rates going, Warsh declined to offer his own dot.

Some Fed watchers expect the shift toward less communication about how the Fed is leaning to increase market volatility, as the Fed will not be there to hold the market's hand when surprising data on, say, the labor market or inflation comes out. That means that unexpected data or policy changes by the Fed could be more market-moving. So on big data days, like the releases of the Consumer Price Index, or on FOMC days, expect bigger moves down or up in the market.

Warsh is looking to measure inflation differently

Second, Warsh plans to change the way the Fed measures inflation. He said he prefers "trimmed averages" for inflation. Current measures of inflation include a range of prices, but Warsh believes some of them are not representative of underlying inflation trends. A trimmed average would remove outliers -- the prices that moved the most in a given period -- to reveal underlying trends in the overall price level.

But many economists believe that trimmed averages tend to understate inflation by counting out so many items. That would mean that if it switches to trimmed averages, the Fed might miss inflation and fail to react accordingly.

Such a scenario could negatively impact the economy and the market in the long run, as the success of both depends on low, stable inflation. Still, the Fed is at this point merely studying the change, and Fed officials typically consult a range of inflation and growth measures, so the jury remains out.

Warsh wants to decrease liquidity in the economy

Finally, Warsh wants to shrink the Fed's massive balance sheet. The Fed currently holds a large portfolio of bonds that it accumulated during two emergencies: the global financial crisis of 2007-2008 and the COVID-19 pandemic. The Fed purchased an enormous volume of bonds during the two crises to inject much-needed liquidity into the economy. That inflated its balance sheet from about $900 billion in 2007 to almost $9 trillion in mid-2022.

The balance sheet currently stands at about $6.7 trillion after the Fed began shrinking it in recent years, but in December of last year, the central bank began buying bonds again to help bring short-term interest rates down (the Fed's added demand for bonds pushes prices up and rates down).

When the Fed purchases bonds in the open market, it injects liquidity into the economy. Some of that liquidity ultimately flows into the stock market, driving prices and indexes higher.

In fact, some market strategists believe market liquidity is the most important factor for asset prices. According to Stanley Druckenmiller, a billionaire investor who for many years was the top portfolio manager for George Soros' Quantum Fund, "most people in the market are looking for earnings and conventional measures. It's liquidity that moves markets."

So, Warsh's changes at the Fed could signal a new era for investors. They're well worth watching.

The Motley Fool has a disclosure policy.