Balance Sheet Reduction Clashes With Fiscal Expansion: Do Kevin Warsh and the White House Really Go Far?

TradingKey - U.S. President Donald Trump explicitly stated in a media interview on Wednesday that if his nominee for Federal Reserve Chair, Kevin Warsh, expresses an inclination to raise interest rates, he will not get the job.

Trump pointed out that current U.S. interest rates are "ridiculously high," emphasizing that "there is no question that we need to cut rates." Trump stated that the U.S. is now a "wealthy country" with continuous capital inflows and rapid economic growth; in this context, lowering interest rates is reasonable and necessary.

He emphasized that it was under his leadership that the U.S. economy achieved a strong rebound, and that the debt issue would appear less prominent in the face of growth.

As for his understanding of Warsh's policy stance, Trump stated he believes Warsh "gets" his intention for rate cuts, and that Warsh originally supported similar views.

In recent years, Warsh has criticized the Fed multiple times for having interest rates that are too high and for making repeated misjudgments, a stance that precisely aligns with the White House's current policy expectations.

However, while Warsh caters to Trump's ideas on interest rates, his advocacy regarding deeper monetary policy tools may diverge from the White House. Warsh tends toward shrinking the Fed's balance sheet to achieve policy easing, a path that is not entirely consistent with Trump's preference for expansionary fiscal policy, harboring potential contradictions.

Internal and External Constraints on Balance Sheet Strategy

Kevin Warsh believes that the Fed's long-term suppression of long-term interest rates through large-scale quantitative easing (QE) not only distorts market prices but also implicitly supports excessive government spending, weakening the binding force of fiscal policy. The net effect has been to make the yield curve higher and flatter, exacerbating market distortions.

Warsh advocates for gradually shrinking the size of the balance sheet to restore the "purity" of monetary policy and allow interest rates to form under more authentic market conditions. However, the reality is far more complex than the theory, and this strategy faces multiple operational constraints.

On one hand, historical experience shows that any previous attempt by the Fed to shrink its balance sheet has been accompanied by a strong market reaction.

For example, in 2013, the mere hint of reducing bond purchases triggered the well-known "Taper Tantrum," causing significant volatility in global markets. Rapid balance sheet reduction tends to push up long-term interest rates, thereby tightening financial conditions and directly conflicting with the goal of cutting rates.

On the other hand, the current financial system is highly dependent on liquidity.

As Joe Abate, interest rate strategist at SMBC Capital Markets, pointed out: "Warsh may wish to reduce the Fed's presence in the market, but large-scale balance sheet reduction is not feasible."

He emphasized that when reserve balances in the banking system fall below approximately $3 trillion, short-term interest rates often experience sharp volatility, undermining the Fed's ability to regulate interest rate targets, which effectively constitutes a floor for balance sheet contraction.

Furthermore, balance sheet reduction is not only a technical issue but also a difficult problem of political and organizational coordination. Several officials within the Fed currently view the balance sheet as a conventional policy tool and may be cautious or even opposed to active contraction in the absence of clear market risks. Therefore, even if Warsh holds a firm stance, he must rely on collective support within the Federal Open Market Committee (FOMC) to put the policy into effect.

In response to this dilemma, analysts believe the Fed can "pave the way" for balance sheet reduction through structural means.

For instance, reducing the compliance burden on banks for liquidity management and increasing the attractiveness of the discount window and Standing Repo Facility (SRF) could make banks more willing to use the short-term liquidity tools provided by the central bank, reducing dependence on excess reserves. This would help release liquidity and provide operational space for moderate balance sheet contraction without disturbing financial markets.

David Beckworth, a senior research fellow at the Mercatus Center at George Mason University, also pointed out that Warsh could use the Fed's existing policy review framework to reassess the strategic positioning of the balance sheet. He suggested the Fed could also consider deeper coordination with the Treasury, such as policy cooperation through bond swaps. He emphasized:

"The Fed is like a large ship that turns slowly, which may be a good thing, because adjustments that are too hasty could cause a shock to the financial system."