"Mutual Combat" Interest Rate Cut Strategy? Can Wash's Move Make Trump's Wish Come True?

When Trump chose Kevin Warsh to serve as the next Federal Reserve Chair, the market generally believed that Warsh would somehow be able to convince the president that he could persuade other Fed policymakers to agree to lower interest rates.

But the question is, how to do it?

For months, one fact has become very clear: among the 19 senior decision-makers at the Fed, not many support rate cuts. Milan, the Fed governor most closely aligned with the White House, has been the “lone voice” calling for a significant reduction in rates.

But economists say Warsh may be plotting a path to get Fed officials to agree to loosen monetary policy: shrinking the Fed’s balance sheet.

Warsh’s previous speeches show that he believes reducing the Fed’s $1 trillion balance sheet has an economic impact equivalent to a 50 basis point rate hike.

Joe Gagnon, a researcher at the Peterson Institute for International Economics, says Warsh will push his Fed colleagues to lower short-term interest rates to offset the tightening effects caused by this balance sheet contraction.

Essentially, Warsh is tightening policy with one hand and loosening it with the other. But doing so can indeed bring rates down.

“Reducing the balance sheet may indeed be an argument Warsh uses to justify the idea that ‘interest rates should be lower,’” said Mark Cabana, head of U.S. interest rate strategy in the U.S. at Bank of America Global Research.

Warsh has long been an outspoken critic of the Fed’s balance sheet size. That balance sheet has expanded from less than $1 trillion before the 2008 financial crisis to more than $6 trillion today.

The Fed currently holds $1.6 trillion in long-term U.S. Treasuries and $1.9 trillion in mortgage-backed securities. This is a huge “footprint” in financial markets.

“If you hold mortgage-backed securities and ultra-long government bonds, then relative to the levels those assets should be at, you’re pushing down their yields,” Gagnon said.

Milan, Trump’s key ally at the Fed, has recently publicly backed this policy. In a speech calling for the Fed to reduce its balance sheet, Milan said the economic impact of balance sheet reduction “can be offset by lowering the federal funds rate.”

“Therefore, resuming balance sheet reduction likely requires further lowering the federal funds rate beyond the baseline forecast,” he said.

Before joining the Peterson Institute, Gagnon served as a senior Fed official. He said that in the process of lobbying to become Fed Chair, Warsh may have told Trump that he had identified a path to cut the federal funds rate by 100 basis points. About 50 basis points of that rate cut would come from responding to the balance sheet contraction, and Warsh may argue that the other 50 basis points could be implemented after higher inflation caused by tariffs and the Iran war subsides.

Warsh will face questioning on Tuesday about his views on interest rates, when the Senate Banking Committee will hold a hearing to consider his nomination to serve as Fed Chair. Lawmakers will focus on whether Warsh will truly remain independent or simply act according to Trump’s wishes.

Warsh’s spokesperson declined to comment.

Warsh will face pressure to cut rates

Warsh’s Senate confirmation still faces major obstacles, but regardless of when he ultimately takes over the Fed, he will face intense pressure from the White House to lower interest rates.

Last week, Trump reiterated his position: rates should be well below the current 3.5% to 3.75% level.

During an interview with Fox Business Network, when asked whether he thinks rates will fall later this year, Trump replied, “Once Kevin is in, I think so.”

He had also joked that if the Fed doesn’t cut rates significantly, he would sue Warsh.

But many Fed officials say they are cautious about cutting rates before progress is made toward the 2% inflation target. The Iran war has pushed inflation to its highest level in two years, making officials even more cautious.

Ben Bernanke, who was Fed Chair in 2008, pioneered the use of the balance sheet. During the worst of the financial crisis, the Fed cut rates to zero, but that still wasn’t enough to stimulate the economy. So, the Fed purchased long-term U.S. Treasuries and mortgage-backed securities to help lower rates and support economic recovery.

In recent years, the Fed has attempted to reduce its balance sheet twice. The first attempt ended with the 2019 market crash, when money market rates surged. The second attempt began in 2022 and ended more quietly last December, but the balance sheet size still reached $6.6 trillion, even higher than the peak in 2017.

Gagnon says that Powell and his colleagues have never come up with a good way to communicate overall monetary policy, including the balance sheet.

Fed officials tend to treat the balance sheet plan as secondary. They often liken it to “watching paint dry.”

“They talk as if the balance sheet is one thing and setting interest rates is another, and they don’t really discuss the connection between the two,” Gagnon said.

“The contents of the balance sheet do affect the policy stance; they should incorporate it into their overall analysis, but they refuse to do so,” he added.

Since the Fed began using the balance sheet in 2008, it has never sold any assets. Instead, it has shrunk the balance sheet by waiting for the held assets to mature and then not reinvesting the proceeds.

This strategy leaves the Fed with a large amount of mortgage assets. But the slow withdrawal as assets mature does not have the same effect on mortgage-backed securities, because most of them are low-interest loans that homeowners are unlikely to repay early—meaning they may not mature for decades.

Warsh’s two paths to shrink the balance sheet

Mark Cabana of Bank of America says the Fed has two options for shrinking its balance sheet.

First, it could announce the sale of assets in the open market. He says the likelihood of this happening is very small.

“Selling assets would cause massive disruption to financial markets. It would tighten financial conditions and lead to a significant decline in the value of risk assets,” he said.

While an economic slowdown could potentially justify rate cuts, the cost would be too high.

“I don’t think Trump would agree to do that at all,” Cabana said.

In a speech last month, Fed governor Milan said he would support selling assets if some securities were profitable at the time of the sale. But Cabana said he believes other Fed officials would not agree.

“If the Fed is trying to realize gains, the market would be very surprised. Most experts would tell you that this is highly unlikely. I would also tell you it’s highly unlikely,” Cabana said.

He said a more feasible option is for the Fed to focus on the liabilities side of the balance sheet—on the $3 trillion in reserves that banks hold at the Fed. Banks hold reserves partly to meet liquidity standards established after the 2008 financial crisis.

Darrell Duffie, a professor of finance at the Stanford Graduate School of Business, says reserves are a useful form of liquidity for banks. They are ultra-short-term and highly liquid assets.

“When banks urgently need funds, this can help them get through a liquidity crisis,” he said in a Brookings Institution podcast.

The Fed wants banks to hold adequate reserves. Meanwhile, Duffie says the Fed is very sensitive to the amount of interest it pays on deposits to commercial banks, because it is often portrayed as “free money” for banks.

“At least for some people—including some in Congress—large banks receiving a lot of interest from the Fed doesn’t look very good,” Duffie said. But he pointed out that it actually carries no real cost, because banks can earn the same amount of interest by holding short-term Treasury bills.

Cleveland Fed President Loretta Mester said in an interview with CNBC last Wednesday that the Fed is trying to balance the financial stability benefits of ample reserves with some reputational benefits that come from shrinking the balance sheet.

Fed Governor Waller put it more vividly in a speech in February: “You don’t want banks, every night, … rummaging through sofa cushions looking for money. That’s extremely inefficient and foolish.”

But reducing the demand for reserves has its limits.

“If banks keep demanding reserves, we can only shrink the balance sheet to a certain extent,” Mester said.

Lou Crandall, chief economist at Wrightson ICAP, a research firm that specializes in the Fed, said the central bank is making progress in exploring potential options for getting banks to hold less excess reserves.

There have already been discussions about reforming the post-2008 liquidity rules—rules that incentivize banks to hold reserves while also setting up programs to ensure that banks can obtain emergency funding when needed.

Duffie said another more controversial idea is to pay lower interest on reserves that exceed a certain threshold.

“If we can find a way to make the banking industry believe it doesn’t need to stockpile that many reserves, then it would allow the Fed to shrink the balance sheet… that would be a win-win for everyone,” Crandall said.

Cabana of Bank of America said that if the Fed can manage to reduce the demand for reserves, it would most likely stick to shrinking the balance sheet by letting assets mature.

Guy LeBas, chief fixed income strategist at Janney Capital Management, said that it took 20 years to develop the complex regulations and policies that require large reserves, and changing those rules is “hard to predict all possible outcomes.”

“I doubt these policies will change anytime soon,” he said.

Shrinking the balance sheet does not necessarily mean lower rates

Although Warsh may argue that shrinking the balance sheet should lead to lower interest rates, some experts are skeptical.

“The argument that cutting by 100 basis points is broadly plausible makes sense, but it’s far from certain,” Jon Faust, a former senior adviser to Powell and now a professor of economics at Johns Hopkins University, said in an email.

“Fabricating a rate-cut story for a Trump who is eager to cut, and convincing a hesitant FOMC, are completely different things,” he added. The FOMC is the body responsible for setting interest rates.

Even if that’s possible, reforming bank regulation would take a long time. It’s unlikely to satisfy a president without patience.

“I doubt the federal funds rate will fall before the midterm elections in November,” Faust said.

Cabana of Bank of America said that in the end, he doesn’t think the market will accept Warsh’s view—that balance sheet shrinkage achieved in a way that doesn’t disrupt financial markets is enough to justify rate cuts.

“This is probably the reasoning they would adopt. But the market would be highly skeptical of this argument. If you decide to cut rates, that increases inflation risks,” he said.