Kevin Warsh's Fed "Regime Change" Could Sink the Stock Market, and the Blame Lies With President Trump

The S&P 500 (SNPINDEX: ^GSPC) returned 12.7% annually under former Federal Reserve Chair Jerome Powell, its best performance under any chairman since Paul Volcker took the position in 1979. Yet President Trump repeatedly criticized Powell and other Fed officials for keeping interest rates too high.

The president's attempts to influence monetary policy didn't stop at verbal attacks. Since Trump returned to office, the Justice Department has launched criminal investigations into Powell and Fed Governor Lisa Cook, moves that many economists warn could erode trust in the central bank.

Enter Kevin Warsh, a former Fed governor who has argued for lower interest rates since last year. "We can begin reform at the Fed with a rate cut, which is just the first step to regime change," he told CNBC in July 2025. Warsh officially replaced Powell as Fed chair in May after securing Trump's nomination earlier this year.

However, Warsh's plans for a regime change in the conduct of monetary policy have been complicated by Trump's attacks on the Fed and his decision to wage war in Iran.

Fed Chair Kevin Warsh and President Donald Trump. Image source: Official White House Photo.

Warsh says the deflationary impact of AI leaves room for interest rate cuts

Warsh believes the Federal Reserve is setting monetary policy based on outdated models that fail to account for the deflationary impact of artificial intelligence. "We are probably in the early innings of a structural decline in prices," he told CNC last year. "AI is going to make almost everything cost less."

Warsh argues AI-driven productivity gains would support lower interest rates. But I doubt that argument will fly in the current climate. Investors actually expect the Fed to raise interest rates early next year to curb inflation tied to the Iran war. If Warsh votes to cut rates any time soon, it could damage the Fed's credibility and sink the stock market.

CPI inflation increased to 3.8% in April, its worst reading in three years, as the Iran war pushed energy prices higher. And the situation is still deteriorating. A forecasting tool from the Federal Reserve Bank of Cleveland shows CPI inflation accelerating above 4% in May and June.

Against that backdrop, rate cuts would be met with extreme skepticism. Investors would wonder if President Trump had compromised the Fed's independence. Even the perception of political interference would make the central bank less credible, and that could have a devastating impact on financial markets.

The stock market could plunge if investors question the Federal Reserve's independence

A politically motivated Fed could not be trusted to make monetary policy decisions in the best interest of the economy over the long term. Instead, policymakers could cut rates to boost the economy for political reasons, such as winning favor with voters ahead of an election. But unnecessary rate cuts would ultimately lead to higher inflation.

Bond investors would anticipate that risk and demand higher yields as compensation. That means they would sell existing bonds (driving prices lower and yields higher) until payouts were sufficiently attractive. New bonds would have to match those rates to stay competitive. That domino effect could hurt the stock market in two ways.

First, higher yields would make bonds more attractive to investors, which could pull money away from stocks. Second, stocks are frequently valued using the discounted cash flow model, and higher yields would compress valuations by reducing the present value of future cash flows.

Kevin Warsh wants to shrink the Federal Reserve's balance sheet

Warsh believes the inflationary impact of rate cuts could be offset by shrinking the Fed's balance sheet, a process known as quantitative tightening (QT). The Fed currently holds $6.7 trillion in assets (two-thirds of which are Treasury bonds), representing a substantial increase from $900 billion in 2007.

The Fed began purchasing bonds in earnest to stabilize markets during the financial crisis in 2008. Interest rates were already near zero, which forced policymakers to get creative. But Warsh thinks the Fed has leaned too heavily on that strategy. He views interest rates as a more even-handed monetary policy tool.

"The Fed has an interest rate tool and a balance sheet tool. My view is the interest rate tool gets in the cracks. It's fairer," Warsh told the Senate Banking Committee during his confirmation hearing. "The balance sheet tool disproportionately helps those with financial assets. The interest rate tool hits the entire economy."

Warsh may be correct, but it doesn't address concerns about Fed independence. If Warsh tries to justify rate cuts by shrinking the Fed's balance sheet, investors may see it as a surreptitious attempt to placate President Trump.

Here's the big picture: Trump's attacks on the Federal Reserve and his decision to take military action in Iran have put Warsh in a tough position. While Warsh's views on AI and the Fed's balance sheet may be spot on, rate cuts in the current climate would raise questions about the Fed's independence, which could cause the stock market to plunge.

Trevor Jennewine has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.