Former Federal Reserve Governor Warsh spoke about tariffs and inflation during a Fox interview. He showed understanding towards some of Trump’s policies. Warsh indicates that we need to change our economic strategies, arguing that current inflation is due to increased money supply, not high wages. He compared today’s situation to the 2008 crisis when the Federal Reserve lowered interest rates to zero and used quantitative easing. He highlighted that a trillion-dollar increase in the balance sheet back then was thought to be equal to a 50-basis point rate cut.

Reducing the Balance Sheet

Warsh suggested that reducing the balance sheet by a few trillion dollars, working with the Treasury Secretary, could act like a significant rate cut. He believes this could enhance the real economy, despite the strong performance of financial markets, such as a booming IPO market. Warsh pointed out that the large amount of money available now benefits the financial sector more than it supports the real economy. He emphasized that genuine economic stimulation could happen through strategies that lower rates and promote growth. The key point in Warsh’s comments is that the current inflation is not mainly caused by wage increases, which some feared. Instead, he attributes it to a rapid growth in the money supply. This shifts the focus from labor markets to earlier monetary actions, particularly liquidity measures like asset purchases. He sees a direct connection between monetary policies from the post-2008 recovery to today’s inflation issues. He also noted that following the 2008 crash, the Federal Reserve’s bold actions—like cutting interest rates to near-zero and making large asset purchases—provided critical support for liquidity. He considers these asset purchases as equivalent to rate cuts, estimating that a trillion-dollar increase in the Fed’s balance sheet equals about a 50-basis point reduction. This insight lays the groundwork for his current proposals.

Coordinating Fiscal and Monetary Policy

What’s his suggestion? Create a way to mimic the effects of rate cuts without changing the actual policy rates. He supports reducing the Federal Reserve’s balance sheet but insists this must happen in collaboration with the Treasury. This detail is crucial—Warsh isn’t just calling for quicker quantitative tightening. He advocates for a coordinated approach between fiscal and monetary authorities. His aim is to redirect excess liquidity from financial markets to the real economy. He believes this could significantly benefit non-financial sectors, especially since capital markets are already thriving, as seen with a healthy IPO environment. It’s also essential to understand where capital has been accumulating. Much of it isn’t flowing into job creation or real investment; instead, it is going into assets like stocks, private placements, and digital instruments—anything promising returns. Warsh questions whether this capital is fulfilling its macroeconomic purpose. This has implications for those assessing risk, affecting not only anticipated volatility but also liquidity premiums. As central banks may start shrinking their balance sheets more actively—seeing this as a hidden tightening mechanism—the real economy could respond differently compared to standard rate hikes. This necessitates a reevaluation of duration exposure. It also suggests that implied rates across derivatives might not fully account for this tightening, especially if central banks’ communications are understated. We must watch Treasury issuance closely. If real coordination between fiscal and monetary authorities emerges, with the Fed actively guiding issuance through strategic balance sheet reduction, we could see rapid and sharp shifts in the yield curve. While shorter-term rates might stay stable for now, intermediate rates could adjust in ways that diverge from recent trends. It’s crucial not to be misled by apparent stability in credit spreads or stock prices. Warsh argues that the activity in asset markets obscures the inefficiency of transmission into the productive economy. This means we should no longer rely on financial sector indicators as accurate reflections of overall economic health. We may need to revise our hedging strategies and pay closer attention to potential funding pressures as liquidity support may unwind more swiftly than futures markets expect. If policymakers head in this direction, financial instruments sensitive to future guidance—like swaps, options on rates, and term premium proxies—might start to show noticeable gaps between expectations and actual moves. This opens up chances for strategic positioning but also carries risks of sudden shifts if the coordination wavers. For now, we not only price current policy rates but also consider the underlying shifts in the philosophy driving them. Create your live VT Markets account and start trading now.

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