Wash takes over from Powell, marking a new era for the Federal Reserve?

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NANHUA FUTURES joined discussion · Feb 2 19:02

After Wash Nomination: Potential Contradictions and Conflicts in Fed Policy

01 Core Viewpoint

Kevin Warsh's formal nomination by Trump to serve as Federal Reserve Chairman has triggered market pricing for liquidity contraction, causing significant market volatility.

If Warsh takes office smoothly, the Federal Reserve may undergo a fundamental transformation of its monetary policy framework – shifting from the current 'post-Keynesian data-dependent model' to 'supply-side monetarism.' The core of this would be implementing an unconventional policy mix of 'rate cuts + balance sheet reduction,' using balance sheet reduction to control inflation and rate cuts to stimulate investment and stabilize employment. Additionally, plans include stripping the Federal Reserve of non-monetary functions and restoring institutional credibility.

However, this transition harbors multiple contradictions and uncertainties: First, the inherent conflict between liquidity and interest rates. Aggressive balance sheet reduction can easily trigger a liquidity crisis, push up long-term interest rates, increase financing costs for the real economy, and create internal tension with the need to stimulate growth through rate cuts. Therefore, it is crucial to focus on the pace and intensity of the balance sheet reduction. Second, external conflicts between policy objectives and White House demands. Warsh's preference for a strong dollar clashes directly with Trump's desire for a weak dollar and debt control goals. Coupled with the choice of policy priorities after inflation rebounds, this may provoke White House intervention in the Federal Reserve's independence. Third, uncertainty regarding appointment nominations. Warsh’s nomination remains uncertain, as procedural hurdles during Senate hearings and full Senate votes could potentially reject the nomination.

Key time nodes need to be closely tracked going forward: the Senate Banking Committee confirmation hearing in February-March, the period around the full Senate vote in March-April, the inaugural speech mid-year, and the June FOMC meeting, with the June FOMC meeting being the core node for verifying whether the 'rate cut + balance sheet reduction' policy will take effect. At the same time, attention should be paid to the timing and method of balance sheet reduction. After Warsh takes office, he might first push for rate cuts before initiating a moderate balance sheet reduction. The specific timing for balance sheet reduction could be postponed until the second half of 2026 or even 2027. The approach to balance sheet reduction may differ from previous passive non-renewal of maturing assets, leaning more toward active and institutional measures.

02 Nomination Confirmed: Market Sees Sharp Volatility

The much-anticipated mystery surrounding the next Federal Reserve Chair has finally been unveiled. After numerous market adjustments of expectations regarding candidates, on January 30, 2026, US President Trump officially nominated Kevin Warsh as the next Federal Reserve Chair. Prior to the official announcement, several media outlets had already disclosed that the Trump administration intended to nominate former Fed Governor Warsh for the position, allowing the market to partially price in the news beforehand. On Friday afternoon, the US Dollar Index gained some support while gold continued its prior weakness.

Following the formal nomination by Trump, the market further intensified its pricing-in of liquidity contraction, leading to sharp volatility: the US Dollar Index strengthened accordingly, rising 0.84% in a single day, marking the largest daily gain since May 2025. Gold, on the other hand, saw its biggest one-day drop in 40 years during the evening session on January 30; by the close, spot gold had fallen 9.25% to $4,880 per ounce.

This market fluctuation was not an isolated event, as earlier market developments had laid the groundwork for such volatility. Previously, the US Dollar Index had already experienced a decline detached from fundamentals due to factors like 'de-dollarization' trades, US-Japan joint forex interventions, and Trump's statements supporting a weaker dollar. Meanwhile, gold witnessed an epic surge this week, driven by the resonance of 'geopolitical disorder' and 'shaken confidence in the dollar system,' alongside market sentiment boosts. Not only did gold break through the $5,000 per ounce mark, but it also approached $5,600 per ounce at one point. The rapid rise in gold and the US Dollar Index’s excessive fundamental decline set the stage for heightened volatility following Warsh's nomination.

03 Core Catalyst: Monetary Policy Framework Restructuring Behind Warsh's Nomination

The reason Warsh's formal nomination increased market volatility lies in the fact that his appointment is not merely a personnel change but signifies a potential fundamental restructuring of the Fed's monetary policy framework — shifting from the current 'post-Keynesian data-dependent model' to a 'supply-side monetarist' paradigm. This shift directly impacts market expectations on liquidity, inflation, and interest rates.

1. Core Policy Proposition: The Unconventional Combination of 'Rate Cuts + Balance Sheet Reduction'

Warsh’s core policy idea is to seek a new equilibrium between low interest rates and combating inflation through the unconventional combination of 'rate cuts + balance sheet reduction.' He argues that high inflation is not solely caused by overheated demand but rather stems from the Fed's excessive expansion of its balance sheet through quantitative easing (QE). As early as 2010, when the Fed launched its second round of QE, Warsh expressed strong concerns, ultimately resigning in 2011 in dissatisfaction with the policy. He proposes that the Fed can simultaneously implement 'hawkish balance sheet reduction' and 'dovish rate cuts.' In a May 2025 interview with the Hoover Institution, he clearly stated, 'Balance sheet reduction can suppress inflation, thereby creating space to lower nominal interest rates,' adding that 'if the pace of money supply can be slowed, interest rate levels can actually be lower.'

2. Functional positioning: Stripping non-monetary functions to reshape the credibility of the Federal Reserve

In addition to the monetary policy mix, Kevin Warsh advocates that the Federal Reserve should divest itself of functions unrelated to monetary policy, arguing that excessive expansion of power would only undermine its credibility. At the 2025 G30 conference, he pointed out in a speech that the Federal Reserve has four major issues, explicitly mentioning “the blurred boundary between monetary and fiscal policy, with QE inflating US debt levels by subsidizing government debt costs,” while criticizing the Federal Reserve for “overextending its reach into socio-political issues like climate change.”

3. Divergence in inflation perspectives

In Kevin Warsh’s policy framework, he rejects the view that “growth leads to inflation,” asserting that inflation is essentially a monetary phenomenon; at the same time, he opposes “curbing inflation at the expense of employment,” advocating that low interest rates can promote investment and create jobs. This forms the core logic behind his proposal of the “rate cut + balance sheet reduction” combination — managing inflation through balance sheet reduction while stimulating real economy investment via rate cuts. His core understanding of inflation fundamentally differs from the current mainstream views within the Federal Reserve.

04 Potential uncertainties and key areas of subsequent focus

Although Kevin Warsh's policy propositions are logically coherent, they face multiple practical contradictions and uncertainties during implementation, significantly increasing the variability in the direction of Federal Reserve policies.

1. Uncertainty brought about by policy conflicts

1) The inherent conflict between liquidity and interest rates. Aggressive balance sheet reduction may trigger liquidity crises and interest rate distortions, creating internal tension against the need to stimulate growth through rate cuts. On one hand, balance sheet reduction will lead to a rapid decline in bank reserves, and if the pace is too fast, it could result in the drying up of money market liquidity, failing to cooperate with rate cuts to lower short-term rates, and might even cause short-term rates to spike. On the other hand, balance sheet reduction directly reduces the supply of long-term funds in the market, driving long-term rates significantly higher, forming a steepening yield curve pattern of 'short-end down, long-end up,' ultimately leading to a rise rather than fall in real economy financing costs, weakening the stimulus effect of rate cuts. Therefore, the pace and intensity of future balance sheet reductions will be particularly important, and this is also a key area of subsequent focus.

2) External conflicts between policy goals and White House demands. Warsh’s policy inclinations have dual conflicts with the core demands of the Trump administration, potentially prompting White House intervention in the Federal Reserve’s independence.

Firstly, exchange rate demand conflict. Warsh’s policy mix (especially balance sheet reduction) tends to support a stronger dollar, while Trump has repeatedly publicly expressed support for a weaker dollar, placing their positions in direct opposition. Trump's preference for a weak dollar stems from the “America First” strategy: first, to help reduce trade deficits, providing price advantages to domestic manufacturing; second, to offset cost increases due to tariffs, helping American exporters maintain market share.

Second, the conflict over debt control. The current US debt has reached $38 trillion, and the Inflation Reduction Act will further expand fiscal deficits. Interest payments, debt rollover costs, and new debt financing pressures are surging, making US bond yields a 'trigger' for determining whether fiscal collapse occurs. This is also the core reason why the Trump administration prioritizes interest rate control. However, the balance sheet reduction pushed by Warsh would push up long-term rates, further increasing fiscal burdens, conflicting with Trump’s debt control goals. The Trump administration's choice of 'prioritizing interest rates over exchange rates' is essentially aimed at easing debt pressure and promoting the return of manufacturing, even at the expense of the strong dollar status and challenging the Federal Reserve's independence. If future conflicts between the two intensify, the White House might intervene in Fed policy through pressure.

In addition, a rebound in inflation could exacerbate the conflict. If inflation data rebounds in the future, based on the Fed’s core mission of 'price stability,' Warsh would most likely prioritize tightening policies (strengthening balance sheet reduction) to control inflation rather than ensuring economic growth. This runs counter to Trump’s economic demands and could lead to more direct White House intervention, undermining the Federal Reserve's independence.

3) Uncertainty in appointment nominations. Warsh’s appointment is not guaranteed. The president's nomination must pass through Senate Banking Committee hearings and voting, followed by a full Senate vote to take effect, and the process currently faces multiple obstacles. First, divisions within the Republican Party. Senator Tillis of the Republican Party has publicly stated that he will oppose all new Federal Reserve nominations until the criminal investigation into Powell is concluded. As a member of the Senate Banking Committee, he may directly obstruct the progress of the hearing. Second, partisan opposition. Warsh’s recent shift to supporting Trump has been viewed by Democrats as a 'politicized' choice. If Republicans cannot form a unified position in the Senate, the nomination may be rejected. Although there is no precedent for a Federal Reserve Chair nominee being rejected in a Senate vote, the above-mentioned divisions could still result in the failure of the nomination or significant delays in the process.

2. Key timeframes to watch subsequently

Based on historical transition patterns and the current Senate schedule, it is crucial to track the following key milestones to predict policy direction and the likelihood of Warsh’s appointment through his policy statements and procedural progress:

1) February-March 2026 (2-8 weeks after the nomination passes): The Senate Banking Committee will hold a confirmation hearing, which will be Warsh’s first opportunity to fully disclose his monetary policy framework and address bipartisan concerns. His statements on the pace of balance sheet reduction, timing of interest rate cuts, and inflation targets will serve as the core basis for the market to assess policy direction.

2) March-April 2026 (around the time of the full Senate vote): Warsh will likely release further policy signals through media interviews and statements to gain lawmaker support. His remarks during this phase could trigger secondary market volatility.

3) Mid-year and subsequent key events: Including the oath-taking speech, the June FOMC meeting and press conference, and the semiannual monetary policy testimony. Of particular note will be his statements on the 'pace of balance sheet reduction' and the 'Federal Reserve's mandate' during the oath-taking speech. The June FOMC meeting will be the critical point to verify whether the 'interest rate cut + balance sheet reduction' policy is implemented.

In addition, the timing and method of balance sheet reduction need close attention. The US money market is already showing signs of liquidity tightness, with overnight reverse repurchase agreements (ON RRP) nearly depleted and significant fluctuations in the secured overnight financing rate (SOFR). If balance sheet reduction is immediately restarted, it could trigger a 'liquidity crunch.'Considering the transfer of power, internal consensus-building, and Trump's interest rate cut demands, Warsh may first push for interest rate cuts after taking office, then initiate a moderate balance sheet reduction. The specific timing of the balance sheet reduction could be postponed until the second half of 2026 or even 2027.

The approach to balance sheet reduction may differ from the previous passive strategy of allowing securities to mature without reinvestment, leaning more towards active and institutional measures.Wash has been strongly critical of the Federal Reserve's holdings of mortgage-backed securities (MBS). To directly reduce the size of its balance sheet, MBS may be actively sold. Additionally, Wash could potentially push for financial regulatory reforms to lower banks' reserve requirements. It is important to note that Wash’s core objective in reducing the balance sheet is to control inflation, rather than simply tightening the money supply, so there is no need for excessive panic over liquidity.

Author: Pan Xiang, Nan Hua Research Institute, Z0021448

After Wash Nomination: Potential Contradictions and Conflicts in Fed Policy

Risk Disclaimer: The above content only represents the author's view. It does not represent any position or investment advice of Futu. Futu makes no representation or warranty. Read more

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