Kevin Warsh, the new Fed Chair
In the end, Trump has nominated a new Fed Chair who until recently was considered one of the least likely candidates. Trump himself has repeatedly stated that he was looking for a chair willing to cut interest rates quickly. Warsh, who served on the Fed for a long time, has never belonged to the so-called “doves,” but rather to the “hawks.” He has always been an advocate of a fairly conservative monetary policy. Why, then, did Trump choose him after all?
What played an important role in this decision is that, until recently, it was widely assumed that Hassett would be appointed. He had long argued that the Fed should cut interest rates aggressively. However, as his appointment increasingly came to be seen as likely, financial markets began to react ever more negatively. Trump gradually started to view this as a risk for the upcoming congressional elections in November.
This does not change the fact that the question remains why Warsh was chosen instead. The answer is fairly straightforward. Over recent years, Warsh has become increasingly convinced that AI will lead to much higher productivity growth. If this proves correct, the U.S. economy could grow at a rate of somewhere between 3% and 5% without inflation rising sharply. This would even be possible with a labor force that is barely growing due to much lower immigration and population aging.
If one accepts this premise, interest rates could be lowered further to support strong economic growth. In addition, Warsh has for some time been highly critical of the Fed’s current policy, arguing that it holds far too many bonds in order to keep long-term interest rates low. According to Warsh, it would be more sensible to significantly reduce the Fed’s bond portfolio and instead lower short-term interest rates further.
The conclusion is that Trump has found in Warsh someone who is indeed in favor of lower interest rates and economic stimulus, but not because he is politically beholden to Trump. He supports this approach for economic rather than political reasons. As a result, he is also likely to be approved by the Senate without much difficulty.
From a market perspective, however, there is a substantial risk associated with his appointment. Many experts believe that productivity will not increase nearly as strongly in the near term. By already cutting interest rates and stimulating the economy based on Warsh’s expectations, a significant risk is being taken. If productivity were to fail to rise meaningfully in the period ahead, inflation could accelerate.
Moreover, there is a high likelihood that, if the Fed adopts such an optimistic outlook, Congress will seize the opportunity to cut taxes and refrain from meaningful spending cuts. This may work out well as long as the economy indeed grows strongly, but it becomes entirely irresponsible if it does not. Government finances would then quickly deteriorate.
It should also be borne in mind that the Fed Chair does not have sole authority. He can steer the central bank to some extent, but the final policy outcome depends on the votes of the other ten Fed members. Based on their voting records, it can already be said that they are far less convinced of a sharp rise in productivity. For them, the guiding principle is much more: seeing is believing.
Warsh’s appointment therefore sends a signal, but it should not be overstated how strongly this will actually influence monetary policy. For the time being, the impact is likely to remain fairly limited.
This also means that we remain concerned about the trajectory of U.S. interest rates over the remainder of the year. We expect Washington to introduce additional measures soon to further stimulate economic growth. This is particularly relevant given that Trump’s popularity is relatively low, largely because many Americans complain about their purchasing power.
The economy is already being strongly supported through both monetary and fiscal policy. If it is stimulated even further while productivity growth remains weak or absent, signs of overheating could emerge toward the end of the year in the form of rising wages and inflation. In that case, the Fed would be forced to raise interest rates instead. This would be supportive for the dollar, but negative for equities, bonds, real estate and precious metals.
