Tense. This Week's Market Focus | Warsh: "Balance Sheet Reduction and Rate Cuts"! Could Short-Term Pressure on US Stocks Follow if He Successfully Takes Office?!

Warsh's Restructuring: From the Return of Monetary Sovereignty to Market Repricing

When Kevin Warsh stood before the Senate Banking Committee at his confirmation hearing, the message he conveyed went far beyond the cautious statements expected of a Federal Reserve Chair nominee. It was a declaration about the future direction of U.S. monetary policy, and potentially a paradigm shift that could reshape the global financial landscape. To fully grasp the depth of this revolution, we need to follow a clear chain of logic: starting from Warsh’s core viewpoints, examining how they might disrupt the Fed’s current policies, then assessing their impact on the U.S. economy, and ultimately reshaping the U.S. stock market.

Warsh's Core Viewpoint: The Return of Monetary Sovereignty

Warsh’s policy stance can be summarized as‘Balance Sheet Reduction and Interest Rate Cuts’running in parallel, but this is not merely a simple policy mix—it represents a complete monetary philosophy.

At the balance sheet level, Warsh explicitly opposes the normalization of quantitative easing (QE). He argues thatQE should only be used as an unconventional tool when interest rates hit the zero lower bound., rather than resorting to unconventional policy tools. Over the past fifteen years, the Federal Reserve expanded its balance sheet from less than $1 trillion before the financial crisis to nearly $9 trillion through three rounds of quantitative easing. This expansion pushed up financial asset prices, enriching Wall Street asset holders but failing to benefit ordinary people on Main Street. Therefore, headvocates a gradual and orderly reduction in the size of the Federal Reserve's balance sheet, urging the Fed to exit quasi-fiscal functions and return to its monetary policy roots.

In terms of interest rates, although Warsh has not made any explicit commitments, a tendency toward rate cuts has already emerged.He believes that compared to balance sheet expansion benefiting Wall Street capital more, lowering interest rates would provide stronger support for the 'Main Street' economy. He emphasized that interest rate policy should be coordinated with balance sheet policy.

In terms of inflation measurement, Warsh advocates for introducing a new framework: adopting"trimmed mean"To exclude extreme price shocks, focus on underlying inflation trends rather than one-time price changes, reduce reliance on the dot plot, and incorporate the AI wave into the assessment of inflation prospects.

In terms of communication style, Warsh sharply criticized the Fed’s current model. He advocates forreducing forward guidance,questioning the value of the dot plot, and believing that the Fed should learn to 'operate in an environment without applause or audiences holding their breath'.

On a deeper level, Warsh’s policy stance reflects the extension of the 'America First' strategy under the anti-globalization wave into the monetary domain – transitioning from being a 'global central bank' that supplies liquidity globally without limits to adopting a new approach that tightly controls the monetary spigot, focuses on domestic productivity, and emphasizes monetary sovereignty.

A disruption to the Federal Reserve's current policies

The existing policy is characterized by the normalization of QE and maintaining a high level of balance sheet size, using core PCE as the main indicator while excluding food and energy prices. Warsh, however, advocates shifting from a 'growth-first' approach to a 'control-first' one. Specific measures include prioritizing reductions in MBS holdings (currently about $2 trillion), lowering bank system reserve requirements through optimizing capital regulation rules such as eSLR, strengthening refined management of repo tools, and enhancing predictability of Treasury issuance. This implies that the Fed will transition from being a 'global liquidity provider' to a 'guardian of domestic currency'.

At the same time, the Warsh framework adopts the 'trimmed mean' method, excluding all extreme price shocks and focusing more on underlying inflation trends. This new yardstick can indeed make current inflation appear milder — Bank of America data shows that the 12-month inflation indicator using the trimmed method averages 2.3%, compared to 3% for core PCE. However, Bank of America economists warn that this approach could backfire: when extreme prices are trimmed, some smaller inflation spikes that would have been excluded may seep into the readings, making inflation indicators higher than existing standards. More crucially, if Warsh insists on using his preferred metric, he may be constrained by his own choice.

The third point is that the Warsh model advocates reducing forward guidance, weakening or even abolishing the dot plot, maintaining silence before meetings, and letting the Federal Reserve 'step back.' Wall Street's reaction to this is mixed: JPMorgan worries that the market will lose its 'rate-cut navigation,' Bank of America warns that reduced transparency may exacerbate market volatility, but some point out that the Fed operated well before the dot plot was introduced in 2012, and less communication might actually make its image clearer.

Impact on the U.S. economy

Warsh's policy proposals will have a profound impact on the U.S. economy, with both positive effects and accompanying risks and challenges.

The positive impacts are first reflected in support for the real economy. Rate cuts provide greater support to the 'Main Street' economy, while balance sheet reduction curbs financial asset price inflation, helping narrow the wealth gap, returning monetary policy to its proper role, reducing distortions in the market, and allowing resources to be allocated more efficiently. Controlling excessive money supply helps maintain the long-term value of the dollar and rebuilds the credibility of the Federal Reserve. At the same time, the AI wave has been incorporated into policy considerations, recognizing its role in boosting productivity, making the policy framework more forward-looking and adaptive to modern economic changes.

However, negative impacts and risks cannot be ignored. The current inflation situation is severe: overall inflation has surged to a two-year high, exceeding the 2% target by more than one percentage point; consumers’ one-year inflation expectations have reached 4.8%, a seven-month high; business input costs are at their highest level since 2022. Using Greenspan's definition of 'price stability'—when price fluctuations are so low that 'nobody talks about it anymore'—the Federal Reserve still has a long way to go before claiming victory.

Policy coordination also faces challenges. Balance sheet reduction requires synergy between fiscal, monetary, and regulatory authorities, with uncertainties in coordinating with the Treasury Department, and political pressures may affect policy independence. Warsh faces an almost impossible task: taming inflation while dealing with Trump’s pressure for rate cuts. Former Fed economist Claudia Sahm warns that Fed chairs who dare to defy Trump’s wishes not only need 'the courage to listen,' but likely also need deep pockets to handle potential legal battles.

Risks during the transition period also deserve attention. Poor control over the pace of balance sheet reduction could trigger liquidity shocks; market expectations may become chaotic during the policy framework shift; and internal cultural changes at the Fed might face resistance.

The impact on different sectors of the economy will show divergence. The financial sector facesreduced liquidity support from balance sheet reduction, butthe combination of 'balance sheet reduction + interest rate cuts'reinforces the procyclical characteristics of finance, benefiting assets driven by long-term financial cycles. The real economy benefits from lower borrowing costs due to interest rate cuts, though there is a disconnect in policy transmission—for instance, mortgage rates have risen instead of falling. The government sector faces tension between balance sheet reduction and high fiscal deficits, requiring coordination with the Treasury Department to optimize bond issuance.

Impact on U.S. stocks

The core logic behind the structural impact of the Warsh model on U.S. stocks lies inThe expectation of excessive dollar liquidity is facing a correction.。

Negative impacts primarily stem from liquidity contraction pressures. Balance sheet reduction directly decreases the supply of dollar liquidity, putting valuation pressure on assets driven by liquidity; asset classes that benefited from QE will face headwinds. Over the past fifteen years, investors have become accustomed to the Federal Reserve's unlimited backstop during crises and liquidity-driven valuation expansion. But Warsh's stance on balance sheet reduction means thatthis 'liquidity put' may be being withdrawn。

Next is the restructuring of market expectations. Reducing forward guidance increases uncertainty, and weakening the dot plot leaves the market without a 'navigation' tool,Short-term volatility may increaseInvestors accustomed to being 'spoon-fed' will have to adapt to a new normal with less guidance.

The third point relates to valuation pressure. The logic of liquidity-driven valuation expansion is weakened, and high-valuation, low-profit growth stocks may face greater pressure. Assets that rely on liquidity tailwinds and have benefited from excessive dollar issuance will experience stress.

However, positive impacts also exist. Rate cuts directly reduce corporate financing costs, benefiting the real economy and indirectly supporting corporate profits. The combination of "balance sheet reduction + rate cuts" strengthens the pro-cyclical characteristics of finance, benefiting assets driven by financial cycles. In the long term, the return of monetary policy to its core role reduces market distortions, fostering a more sustainable market environment.

More importantly, the mechanism of money creation will gradually shift from exogenous money back to endogenous money. This means that future liquidity provision will increasingly depend on credit demand from the real economy rather than central bank balance sheet operations. For markets accustomed to the central bank's "feeding bottle," this will be a lengthy weaning process.

From a time perspective,During the short-term transition period,Market expectation adjustments, increased volatility, and expectations of liquidity contractionPressure on valuations。Medium-termThe domestic policy framework gradually becomes clear,The effects of interest rate cuts begin to show,And the market adapts to the new communication model.Long-termIn terms of the monetary creation mechanism shifting from exogenous money back to endogenous money,The financial pro-cyclical characteristics have been strengthened, forming a healthier market ecosystem.

Asset performance will show structural divergence. Pressured assets include: those driven by liquidity, asset classes that benefited from excessive dollar issuance, and high-valuation, low-profit growth stocks. Benefiting assets include: those driven by financial cycles, stocks closely linked to the real economy, and sectors benefiting from productivity improvements (such as AI-related sectors).

Conclusion

Wash's policy proposals are not merely technical adjustments but rather a fundamental restructuring of the monetary policy framework: from quantity to price (balance sheet reduction + interest rate cuts), from global to local (return of monetary sovereignty), from transparency to flexibility (reduced forward guidance), and from expansion to control (tightening the monetary spigot).

Whether this restructuring will succeed depends on whether Wash can strike a balance between political pressure, market volatility, and economic realities. This is a high-stakes gamble, with the credibility of the dollar, the independence of the Federal Reserve, and the stability of the global financial system on the line.

History will remember this moment: when the Federal Reserve attempts to withdraw from the ocean of liquidity it created, when the pendulum of monetary policy swings from one extreme to another, and when a paradigm shift quietly begins in the hearing rooms of Washington. For the markets, this means higher uncertainty, less 'navigation,' and more intense volatility. But for the long-term health of the U.S. economy, this may be a necessary return – a return to the proper role of central banks, the essential function of money, and the appropriate boundaries of policy.

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