The Federal Reserve's centralized reform and Walsh's open scheme

Prologue

On June 17, 2026, the new Federal Reserve Chairman Kevin Warsh made his debut, bringing something different to the Fed:

1. Removed forward guidance, significantly slimmed down the statement;

2. The chairman does not publish the dot plot;

3. Established five major working groups;

These changes are explicit; however, some changes are implicit. For example, the Fed's monetary framework has quietly shifted from an abundant reserve framework to a scarce reserve framework.

As shown in the figure above, since entering the rate-cutting cycle, the one-year Treasury yield has consistently been lower than the effective federal funds rate (ps: short-end yield curve inversion), but recently, the one-year Treasury yield has crossed above the federal funds rate, and the gap between the two is widening (ps: short-end yield curve positive slope).

Many investors are still using the framework from the Powell era to think about problems, so they attribute this phenomenon to "market expectations of rate hikes."

However, the yield on the thirty-year Treasury has fallen back to the January midpoint, which does not support the explanation of "market expectations of rate hikes" (ps: if there were expectations of rate hikes, the thirty-year Treasury yield should be higher).

So, what other mechanism can explain the phenomenon of "short-end yield curve positive slope"? The monetary policy framework has shifted. Under the scarce reserve framework, the short-end yield curve must be positively sloped.

The Scarce Reserve Framework and Its Core Features

As shown in the figure above, the core feature of the scarce reserve framework is: there is a gap between the supply and demand of medium- to long-term funds. That is, the demand for medium- to long-term funds is persistently greater than the supply of medium- to long-term funds.

In this case, the market has an incentive to borrow short-term funds from the Fed, thus causing the effective federal funds rate to be lower than the one-year Treasury yield, i.e., a positively sloped short-end yield curve. Moreover, the larger the medium- to long-term funding gap, the greater the deviation of the one-year Treasury yield from the effective federal funds rate, i.e., the larger the positive slope of the short-end yield curve.

As shown in the figure above, under the cover of the "US-Iran conflict," the US short-end term spread has quietly turned positive and climbed to a high of 46bp.

If Brent oil prices remain high, it would be reasonable to explain the high short-end term spread with "expectations of rate hikes." However, Brent oil prices have already fallen back to around $73.

The Dot Plot and the Abundant Reserve Framework

Although most people know that Warsh wants to abolish the "dot plot," what they don't know is: the foundation of the dot plot is the abundant reserve framework.

As shown in the figure above, the core feature of the abundant reserve framework is: there is a surplus in the supply and demand of medium- to long-term funds. That is, the supply of medium- to long-term funds is persistently greater than the demand for medium- to long-term funds.

In this case, the market has an incentive to deposit short-term funds with the Fed (ps: forming RRP account balances), thus causing the effective federal funds rate to be higher than the one-year Treasury yield, i.e., an inverted short-end yield curve.

In this case, if we still want the short-end yield curve to be positively sloped, what should we do? Make the market expect rate hikes. So, how do rate hike expectations arise? From the dot plot.

Thus, we discover a more interesting fact: the abundant reserve framework is the foundation for the effective operation of the dot plot. Only under the abundant reserve framework can short-term Treasuries accurately reflect expectations of rate cuts or rate hikes.

As shown in the figure above, the current two-year Treasury yield is around 4.07%. If the supply and demand of medium- to long-term funds are abundant, then this rate implies rate hikes—that is, it suggests two 25bp rate hikes in the future.

However, the current situation is: the supply and demand of medium- to long-term funds are no longer abundant, and investors cannot effectively distinguish whether the rise in short-term bond rates is due to temporary tightness in medium- to long-term fund supply and demand or due to increased expectations of rate hikes.

In summary, we can understand that the abundant reserve framework is the soil for the survival of the dot plot, because it removes the "noise" brought by the scarce reserve framework (ps: all temporary factors cause changes in short-term bond prices), allowing all investors to cleanly trade expectations of rate hikes and rate cuts.

Obviously, as RRP account balances go to zero and the short-end yield curve turns positively sloped, Warsh has quietly uprooted the foundation of the dot plot. Completely abolishing the dot plot is only a matter of time (ps: under the scarce reserve framework, calculating rate hike expectations becomes extremely difficult).

The Game of Power Distribution

So, why did Warsh shift from the abundant reserve framework to the scarce reserve framework? Because he wants to centralize power; he wants to fully control the Fed.

As shown in the figure above, during the Powell era, the Fed chose the abundant reserve framework. The Fed's actions in injecting funds became less important (ps: execution-level power was neutered), and the focus of monetary policy shifted to the Fed's guidance on interest rates (ps: decision-making-level power was strengthened). The Fed used forward guidance and the dot plot to evenly distribute interest rate decision power among the FOMC voters and the entire market. In simple terms, this was an extremely decentralized model—when problems arose, the voters and the entire market took the blame.

Symmetrically, once the Fed chooses the scarce reserve framework, the Fed's actions in injecting funds become extremely important.

As shown in the figure above, with the effective federal funds rate R remaining unchanged, the Fed can choose to temporarily tighten monetary policy, i.e., reduce the injection of medium- to long-term funds, causing the one-year Treasury yield to rise sharply from R* to R**. In this case, the deviation of R** from R is larger than the deviation of R* from R, reflecting the Fed's immense discretionary power.

For example, currently the effective federal funds rate is at 3.63%, but the Fed has ways to make the one-year Treasury yield at 3.94%, a deviation of 30bp+. This bypasses both the dot plot and the resolution.

In summary, under the abundant reserve framework, execution-level power is extremely compressed, and the Fed's power is concentrated at the decision-making level; under the scarce reserve framework, execution-level power is greatly strengthened, while the Fed's decision-making power is significantly diluted. The most concentrated reflection of this is: you can set it at 3.63%, but I will execute it at 3.94% according to my own thinking.

Conclusion

In summary, if we still cling to the old calendar from the Powell era, we will still think that the speeches of FOMC voters matter, and that the persistently high two-year Treasury yield is due to rate hike expectations. Once we shift our thinking and immerse ourselves in the "scarce reserve framework," we will find:

1. Only Kevin Warsh's speeches are important;

2. Only the Fed's injection actions themselves are important;

3. What the market thinks is no longer important;

To be honest, every profession has its own expertise. Most people find it hard to understand how a Fed chairman can centralize power.

In fact, Chinese investors have been in a scarce reserve system for a long time and have accumulated enough intuitive experience. It's time for American investors to learn from Chinese investors.

In this field, there is a most awesome term called "cutting reserve requirements and cutting interest rates." Look, "reserve requirements" comes before "interest rates," "quantity" is more important than "price."

As shown in the figure above, the People's Bank of China lowered the OMO rate from 1.50% to 1.40% in early May 2025 and kept it unchanged for a long time, but the one-year certificate of deposit yield fluctuated by as much as 30bp above 1.40%.

This shows that under a scarce reserve system, the central bank has extremely high discretionary power. Sometimes it injects more, and the actual rate is lower; sometimes it injects less, and the actual rate is higher. Therefore, Chinese bond investors are more concerned about the central bank's "injection actions" and try various methods to predict the central bank's "pre-move."

Finally, when Warsh focuses all investors' attention on the "Fed's injection actions," who will have the mind to guess "how many rate hikes in the future"? Who will have the mind to listen to other FOMC voters' "unsubstantiated empty words"? By then, no one will question Warsh's "balance sheet reduction and rate cuts" anymore.

Similar to the previous article, at this point, I still believe that in Q4 2026, there is a high possibility of a rate cut in the US, most likely with the usual routine of a Jackson Hole hint and three 25bp cuts.

ps: Data from Wind, images from the internet

Source: Cang Hai Yi Tu Gou

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