Fed's independence & credibility headache. Is Kevin Warsh a cure or a crisis trigger?

 

Significance of the article

The US dollar is the major currency that drives the global monetary and economic system. Therefore, the governance of the US central bank, the Fed, being the guardian of the dollar through its monetary policy is of prime importance to the global economy because any change in the flow of the dollar supply and prices caused by the Fed has the potential of shocking all corners of the global economy. 

Therefore, it is the standard practice of financial dealers and investors around the globe to speculate on Fed's monetary policy and carry on deals on the dollar. As Kevin Warsh is expected to assume duties as the new Fed Chair for a new term of four years beginning 15th this week, such speculations have become a global event.

Therefore, this article will help formation of strategies to deal with the dollar and Fed policies under the Fed Chair Kevin Warsh.

Article's background and purpose

The non-stop headache suffered by central banks world over is how they keep their policy independence and credibility in managing and balancing of respective economies. Given the global dominance of the US dollar, almost all central banks follow the operational model of the Fed. Therefore, the Fed's developments in independence and credibility govern them of other central banks. As there are no standards or definitions to gauge the central bank independence and credibility, central banking rhetoric is full of different versions depending on ideologies of those who govern respective central banks from time to time.

The headache has now spread to an unbearable level as the US President Donald Trump has been exerting a public pressure since January 2025 on the Fed to cut interest rates by a sizable amount to facilitate his new tariff-based domestic economic policy. As the Fed's independence-minded response is contrasting, the Trump Administration has commenced in intervening in governance and operations of the Fed in numerous ways.

• First, Trump has criticized the Fed's interest rate policy as always being late and inappropriate. This conflict happened in his first term (2017-2020) too when the Fed kept raising interest rates from 0.50%-0.75% to 2.25%-2.50% by total of 1.75% in strait 7 occasions in 2017 and 2018 citing inflationary pressures possible in the future due to excessive money printing carried out to deal with the US/global financial crisis 2007/2009. Later in 2019, the Fed gave up the rate hiking policy and accepted that it was a policy error. Trump now insists that he as the executive President has the public right to propose to the Fed his views on interest rate, especially, given the colossal interest cost on federal debt stock influenced by the Fed's interest rate decisions.

• Second, Trump has removed a Fed Governor for cause fabricated from a mortgage loan irregularity reported prior to the appointment as the Fed Governor. Both the court of Appeal and Supreme Court have stayed the removal and the case is pending before the judiciary.

• Third, the US Attorney General has commenced criminal investigations against the Fed Chairman Gerome Powell based on his last testimony to the Congress on the progress of the renovation of the Fed building. The cost of around USD 3 billion that has exceeded the building renovation budget is alleged as unnecessary and poor efficiency. Trump himself visited the building cite publicly and criticized the cost while simultaneously requesting the Fed Chair to cut interest rates. 

• Fifth, the Fed Chair has approached the Appeal Court and got a stay order against the investigation. Accordingly, the Attorney General has now closed the investigation file. However, the Trump Administration states that the investigation could resume when necessary. Meanwhile, the Fed Chairman at his last monetary policy press conference held on 29 April stated that, although his term as the Chairman is to end on 15th this week, he would continue to serve as a member of the Fed Board of Governors during the term due to end on 31 January 2028 while staying at a low key until the investigation matter is resolved.

• Fifth, Trump has nominated Kevin Warsh to the Fed Board of Governors as the Chair to commence on 15th this week. The Senate approval is being waited.

As such, tensions developing between the Fed and the Trump Administration reveal chronic issues in the governance and policy credibility of the Fed. Consequently, the global financial club and its media network have aggressively stood up to protect the Fed's independence alerting that interest rates might rise unnecessarily if the Fed independence is not protected. Meantime, while some analysts are optimistic of Kevin Warsh to drive a new regime for the Fed, many alert that he will be just a conduit of the Trump Administration to intervene in the Fed's policies suited to the Trump Administration. The Wall Street is with full of sentiments for Kevin Warsh being a partner of a large Wall Street equity firm whereas the Treasury Secretary also has come from the same firm.

Therefore, the purpose of this article is to shed light on the Fed's policy-making culture and challenges to Kevin Warsh as the Fed's new Chair.

Gauging the Fed's Independence and credibility

Independence is the operational freedom of policy-making to deliver the goals within the applicable laws. Credibility is the general recognition of the efficiency in the delivery of such goals. However, independence will not necessarily guarantee the deliverables as required. Therefore, credibility depends on the organizational structure and ability and efficiency of those who are in charge of the delivery of goals. Accordingly, to assess independence and credibility, it is necessary to review the organization structure, its goals and the past effectiveness of the Fed.

Fed's organization

The Fed was established in 1913 on the basis of a proposal submitted by a bankers' club led by J P Morgan to establish a state currency (Greenback)-based monetary system and thereby to protect private banks from financial crises through the lender of last resorts. The proposal was designed secretly to stop a series of banking crises during the private bank currency system that evolved prior to 1913.

Accordingly, the Fed is a bizarre central bank model owned and operated by a mix of the federal government and private banks whereas almost all other central banks in the world are state owned and controlled institutions. The Fed's legal structure is as follows.

• Fed Board of Governors in Washington D.C. - 7 members along with the Chairman, Vice Chairman for monetary policy and Vice Chairman for Supervision nominated by the President and confirmed by the Senate for a term of 4 years. They can be removed only for cause. This Board is responsible for policy decisions and supervision over the Fed system.

• 12 Reserve Banks for identified reserve bank districts owned and managed by member banks - Each Reserve Bank is governed by a Board of 9 members where 3 are appointed by the Board of Governors while other 6 are appointed by member banks. Feds monetary and bank supervisory operations are carried out by these Reserve Banks. In fact, Reserve Banks operate as central banks for member banks in respective reserve districts.

• Reserve Bank Branches - Except for three Reserve Banks (New York, Boston and Philadelphia), others have at least one Branch governed by separate boards appointed by the respective Reserve Banks in the District and Board of Governors.

• Federal Market Operations Committee (FOMC) - The FOMC is the authority responsible for open market operations under the Fed's monetary policy inclusive of underlying interest rates. The FOMC consists of 7 Governors, President of Reserve Bank of New York and 3 Presidents representing other 11 Reserve Banks for a term of one year on a rotation basis. Open market operations as decided by the FOMC are carried out by the Reserve Bank of New York while other financial and credit operations of the Fed are carried out by all Reserve Banks. Therefore, the Fed's governance is such that its monetary policy decisions are largely private sector decisions. It is strange that a fixed dividend of 6% is paid to Reserve Banks before the Fed declares its profit/loss. 

Accordingly, the dollar or the state currency issued in the US monetary system as at present is about US$ 44 trillion consisting of 5.5 trillion of reserve currency stock and 39 trillion of federal debt stock which is the result of the cumulative federal spending net of taxes or fiscal deficits. This is roughly138% of the US GDP.

Fed's monetary policy objectives or goals

The Fed is required by law to maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of

• maximum employment, 

• stable prices and 

• moderate long-term interest rates.

In addition, the Fed's responsibility for the financial system stability through the open market operations and bank supervision from its inception is well understood and documented although a particular financial stability goal is not stipulated in the law.

However, the Fed's policy rhetoric has evolved to a narrow, bureaucratic goal of inflation target of 2% measured from the personal consumer expenditure price index published monthly by the federal bureau of labour statistics as a measure for gaging stable prices while parallelly considering the movement of monthly unemployment rate published by the same agency for gauging the maximum employment level. However, unlike 2% inflation target for stable prices, the Fed does not have any target for the maximum employment or unemployment rate. Further, nobody talks about the goal of moderate long-term interest rates as interest rate is used as the policy instrument for other two goals, i.e., maximum employment and stable prices.

The policy ideology has been the control of the demand side of the economy through the flow of credit in aggregate. This is based on the old ideology of inflation being the result of monetary expansion that affects prices through the demand side of the economy while the supply side is treated as external beyond the control of the monetary policy. Therefore, the policy conflict between price stability and maximum employment is recognized in the conduct of the monetary policy for balancing the goals.

Accordingly, the present monetary policy model of the Fed has been operationalized in the following bureaucratic operations primarily targeting the interest rates and liquidity (or bank reserves) in the overnight inter-bank credit market or federal funds market. Operating instruments used by the FOMC and Fed Board effective at present are as follows.

• Decision on the federal funds rate target - This is the key policy decision that drives the monetary policy operations. The present target is 3.5%-3.75%. Accordingly, the Fed will undertake monetary operations to ensure that the overnight federal funds rates remain within the Fed's target range. It is this interest rate that the President Trump antagonizes with the current Fed Chairman for not cutting to around 1%.

• Rate of interest paid by the Fed on bank reserve balances at the Fed - This is used as a lower bound for federal funds rates in the market as banks will not lend to other banks below this rate. This rate is 3.65% at present.

• Primary credit facility or discount window - The Fed offers discount credit facility to member banks up to 90 days. The interest rate is 3.75% at present.

• FOMC desk to conduct open market operations (OMO) as necessary to maintain federal funds rates within the Fed's target range. OMO are the Fed's trades of government securities with member banks in order to affect the levels of bank reserves (or liquidity) held at the Fed which in turn affect the federal funds rates. Specific OMOs approved by the FOMC at present effective are as follows.
• Conduct standing overnight repurchase agreement operations at an interest rate of 3.75%. This is the Fed's overnight lending to member banks against government securities to inject new reserves to the banking system. This will ensure the upper bound for federal finds rates.
• Conduct standing overnight reverse repurchase agreement operations at an interest rate of 3.5% with a per counter-party limit of US$ 160 bn per day. This is the Fed's overnight borrowing from member banks against government securities used to mop up excess reserves from the banking system. This will ensure the lower bound for federal finds rates as banks will not lend to other banks below this rate.
• Rollover over at auction all principal payments from the Fed's holdings of Treasury securities.
• Reinvest all principal payments from he Fed's holdings of agency securities into Treasury bills. This is to ensure that Fed's assets and thereby reserves do not decline.
• Increase the Fed's holding of securities through purchases of Treasury bills and other Treasury securities with a remaining maturity of 3 years or less in order to increase reserves or maintain an ample level of reserves in the banking system.

Recent performance on goals

The Fed's performance record throughout the past does not reveal the Fed's credibility of delivering of statutory goals. The US history after the Fed is full of cycles of inflation, unemployment and financial crises from time to time like in prior period. They are largely attributable to the Fed's bureaucratic policy models and underling ideologies applied irrespective of economic problems confronted by the public from time to time. The center of the poor performance is the adherence to the new liberal policy ideology since1970s.

Expectation of a new monetary regime from Kevin Warsh

Financial media expectations for a new regime of the Fed to be led by Kevin Warsh are not new but presented as new. The main contents are of five items, i.e., interest rate cuts, reduction of the Fed balance sheet, fixing the federal debt problem, 1952 styled Treasury-Fed Accord and AI-induced productivity boom. 

However, no analyst seems to pay attention to whether the Fed's bureaucratic structure is flexible to facilitate all such liberal contents. It is highlighted that almost all Fed Chairmen in the recent past entered the Fed with ideas of regime changes and departed the Fed as victims of the operating structure in tact.

Five contents listed above are highlighted below without getting into underlying rhetoric.

• Interest rate cuts

Markets expect Kevin Warsh to cut interest rates at least by 1% during this years to satisfy the wish of President Trump. However, rising inflation consistently, which is 3.5% at present, above the target of 2% is the fundamental problem preventing such interest rate cuts. Therefore, the Fed's monetary policy model linked between interest rate and inflation rate will not permit Kevin Warsh to start rate cuts soon in the prevailing inflation outlook.

• Reduction of Fed's balance sheet or regime change

The size of the Fed balance sheet or asset volume has become a major monetary concern after two rounds of quantitative easing or excessive money printing carried out by the Fed in response to the financial crisis 2007/09 and global Corona pandemic 2020/2021. Accordingly, the Fed's balance sheet has expended from 0.9 trillion in 2007 to 8.9 trillion in 2022 and now reduced to around 6.7 trillion with reserves held by banks around 3 trillion. Therefore, the current monetary regime is presented as ample reserve regime.

The major concern over the present Fed's balance sheet are two fold. First is the future inflation likely to be fueled by excess reserves in view of the present monetary ideology. Second is the federal debt monetization by the Fed as nearly 96% of the Fed balance sheet contains Treasury and agency securities.

Therefore, ideology of Kevin Warsh is to reduce the balance sheet by selling its holding of Treasury securities in the market so that private demand and market will expand for Treasuries and deficit financing.

However, three fundamental problems arise here. First, private market for Treasuries will constraint the ability of the Fed to control interest rates aligned to its interest rate targets if the Fed's holding of Treasuries is a low volume. Second, the demand for reserves or money printing by the Fed is not targetable as it is beyond the control of the Fed. The Fed's mandate is to provide reserves to the economy to meet the demand and to prevent liquidity crunches. Third, there is no macroeconomic or statistical formula to determine the optimum of level of reserves/Fed balance sheet desirable for the economy. The Fed's general practice is to provide reserves from time to time to meet the demand of banks and other Fed reserve account holders so that the monetary system is stable.

• Fixing the federal debt problem

The federal debt stock that has risen to 39 trillion with nearly one trillion of annual interest payment at present is not a problem resolvable by the Fed. The only help the Fed can provide is to keep interest rates low to ease interest payment and rollovers and the Fed to buy some of debt. However, none is directly possible in the current market-based monetary policy regime.

However, low interest rate policy can help reduce debt stock in real terms and in GDP ratio. The low interest rate regime will reduce debt rollover cost while resulting high inflation and GDP growth will reduce the real value and GDP ratio of the debt stock. This policy strategy is known as financial repression on the private sector that has been adopted after the second world war. However, the present Fed's policy governance model does not facilitate the Fed to assist such a strategy at a cost to the economy. Therefore, only option available to the Fed is to buy Treasuries and expand the Fed balance sheet to assist the government to manage the rising debt stock.

• 1952 styled Treasury-Fed Accord

1952 Fed Accord provided the Fed with the independence for fixing interest rates and the control over reserves and money supply. This policy shift was required for the Fed to conduct the monetary policy to control inflation as the policy environment up to 1951 was the Fed keeping interest rate pegged at low to keep the government borrowing cost low after the world war II while tolerating high inflation rising to 21% in early 1951.

Accordingly, a similar accord is proposed to agree on formalities for independent monetary policy and independent fiscal policy in a market environment. However, given the inter-dependence of the fiscal policy and monetary policy being the two sides of the same coin, such accords can never be implemented in the real world. It is the general knowledge that monetary side of the economy gets changed frequently in response to fiscal operations such as spending, taxes, deficit and debt where the Fed has to provide monetary reserves on a daily basis for the settlement of fiscal operations in order to keep the Fed's interest rate targets.

• AI-induced productivity boom

Kevin Warsh believes that the on-going development of AI will boost the productivity and, therefore, low interest rate regime with reduced Fed balance sheet will not cause concerns over inflationary pressures. Therefore, he strongly believes in AI bubble to assist him in driving a new monetary regime. However, AI or productivity is not a policy variable falling under the control of the Fed where it is only a business sector factor to be considered in the Fed policies as in the past.

Concluding remarks

• It is common to hear such ideological expectations when a new Fed Chair is to assume duties. It is also common for other central banks.

• However, the Fed operates in highly bureaucratic and ideological economic management culture built in a long period of time. Therefore, one individual as the Fed Chair cannot make a regime change or even a slight adjustment to the policy model. In that context, the only option available to Kevin Warsh is to follow suit the existing policy and institutional culture. However, he might change the policy communication language if he is sufficiently knowledgeable in the Fed's policy literature.

• The outgoing Fed Chair Jeromy Powel made a remarkable change in the policy language to present ground facts in plain language. He is not a PhD Economist and never used complex economic theories or concepts to support the policy decisions. He only explained what the Fed was doing in the present model and accepted its failures and inabilities. He never tried to lie or cover up lapses but replied that the Fed had no knowledge or instruments.

• The Fed's current monetary policy model is to set the target for overnight inter-bank market interest rate and provide or print reserves to keep interest rates within such targets. The mode of printing reserves is the trade of Treasuries which indirectly monetizes the fiscal operations and stabilizes Treasury yields. In addition, it has a habit of cutting interest rates to around zero during crisis or recessionary times and print reserves freely to boost employment and growth. This policy model is a framework linked to new liberal market-based operation where distributional aspects and concerns are not considered.

• The President Trump is only interested in cutting interest rates sizably to reduce fiscal cost. However, the existing Fed policy model and underlying ideology are not supportive for such a drastic policy shift. Further, monetary policy decisions are almost private sector decisions, given the Fed's governance model, although the dollar currency is a public good with public economic goals. Therefore, Kevin Warsh will soon be a person most hated by the President Trump as the envisaged interest rate cuts will not come soon. Further, if he rushes for a regime change by a rapid reduction in the Fed balance sheet and holding of Treasury securities, a systemic risk of a financial market crisis due to a reserve crunch is highly likely. Whether the risk is real or not is a decision of few market dealers. In that context, Kevin Warsh will be a victim of three parties, i.e., President Trump, Fed's policy model and Wall Street, where no economic formula is available to guide the balance.

• The spillover effects of such tensions in the Fed to the global economy, especially to countries such as Sri Lanka living on the US dollar reserve and following the Fed monetary policy model, will be fatal and add to the existing war uncertainty and shocks.

• It is noted here that Ben Bernanke, a Princeton Economics Professor, entered the Fed Chair seat in 2006 after Alan Greenspan of 18 years and miserably failed to prevent the financial crisis in 2007/2009. To deal with the crisis, he cut interest rates from 5.25% in June 2007 to zero in December 2008 and raised money printing from 0.9 trillion to 4 trillion during his office. After his departure in 2013, he commented at a BBC interview with Mervyn King, former Bank of England Governor held on 29 December 2014 that " most of Fed meetings got a lot of tensions and were deadly boring and very scripted. The staff do other work, they write communiques in advance of decision-making." This shows the deep bureaucracy prevailing in the Fed where no policy and ideology shift is permitted. Therefore, it is hoped that Kevin Warsh will not be another crisis trigger like Bernanke.

• Until inter-dependence of fiscal operations and monetary operations where the monetary side of the economy is the sovereign currency-based fiscal policy is understood in its reality and central banking is redesigned to support the fiscal operations with targets to promote greater distribution of economic welfare and living standards across the public and societies, the existing central banking ideology will be a major conduit for social and political conflicts detrimental to the humanity. Therefore, central bank independence and credibility headache is a never curable disease.

• In this context, it is advisable that central banks in other countries follow their own policy models suitable for respective economies and resources as these central banks are state/public institutions unlike the US Fed and its global currency dominance. Otherwise, these central banks will continue to be victims of the Fed and global financial dealers operating behind the Fed.

(This article is released in the interest of participating in the professional dialogue to find solutions to present economic problems and difficulties confronted by the general public. All contents in the article are based on the author's research and views on the subject which have no intension to personally discredit characters or ideologies of any individuals.)

P Samarasiri

(BA Hons Economics, University of Colombo, MA Economics, University of Kansas)

Former Deputy Governor, First Central Bank of Sri Lanka

(35 years of experience in staff class in the Central Bank, inclusive of Director of Bank Supervision, Assistant Governor, Secretary to the Monetary Board and Compliance Officer of the Central Bank, Chairman of the Sri Lanka Accounting and Auditing Standards Board and Credit Information Bureau, Chairman and Vice Chairman of the Institute of Bankers of Sri Lanka, Member of the Securities and Exchange Commission and Insurance Regulatory Commission and the Author of 13 Economics and Banking Books and a large number of articles published.)