The next chairman of the Federal Reserve is changing! Waller's policy proposals: interest rate cuts + balance sheet reduction

Deutsche Bank analyzes that if Kevin Warsh is elected as the Federal Reserve Chairman, his policy proposals may present a unique combination of "interest rate cuts and balance sheet reduction in parallel."

On December 16, Wall Street Journal mentioned that U.S. President Trump stated in a media interview that former Federal Reserve Governor Kevin Warsh has emerged as a leading candidate for the Federal Reserve Chairman position alongside Kevin Hassett. He said:

I think both Kevins are great.

Trump's statement led to a significant decline in Hassett's odds in the prediction market Kalshi. As of Tuesday, data from Polymarket showed that the prediction market believes Warsh has a greater chance than Hassett of becoming the next Federal Reserve Chairman.

On December 15, according to news from the trading desk, Deutsche Bank's Matthew Luzzetti team published a research report that deeply analyzed Warsh's policy proposals. The report analyzes that if Warsh is elected, he will support interest rate cuts but will also demand a reduction in the balance sheet.

The report points out that the premise of "interest rate cuts and balance sheet reduction in parallel" is that regulatory reforms reduce banks' reserve requirements, and the feasibility in the short term is questionable.

Deutsche Bank believes that the market needs to closely monitor whether the new chairman can maintain independence under the pressure of Trump's demand for significant interest rate cuts, as well as the process of establishing his policy credibility.

Warsh's Background

Unlike economist Hassett, Warsh comes from a legal background and has extensive experience in both the public and private sectors.

In the public sector, he served as a Federal Reserve Governor from 2006 to 2011, during which time the Federal Reserve was responding to the global financial crisis, and he played an important liaison role between the Federal Reserve and the market.

He has been highly critical of the Federal Reserve's aggressive balance sheet operations over the past 15 years, arguing that quantitative easing has deviated from the central bank's core responsibilities.

Warsh is currently a partner at the Duquesne family office of Stan Druckenmiller, as well as a distinguished visiting scholar at the Hoover Institution and a lecturer at the Stanford Graduate School of Business.

This experience spanning academia, regulatory agencies, and the investment community gives him a profound understanding of financial markets and monetary policy.

Warsh's Attitude Towards QE

Deutsche Bank points out that in recent years, Warsh has made numerous criticisms of the Federal Reserve, involving both short-term policy decisions and long-term strategic considerations.

First, Warsh has consistently criticized the Federal Reserve's aggressive use of the balance sheet over the past fifteen years.

Although he supported the Federal Reserve's quantitative easing (QE) program in response to the global financial crisis, he warned that continuing QE thereafter is inappropriate, as it may trigger inflation and financial stability risks, and cause the Federal Reserve to deviate from its core responsibilities by intervening in credit allocation policies that could distort market signals.

The report cites Warsh's recent remarks:

In the summer and autumn of 2010, amidst strong economic growth and financial stability, I was extremely concerned that the decision to purchase more government bonds would entangle the Federal Reserve in the complex political affairs of fiscal policy. The second round of quantitative easing was introduced, and I disagreed with this decision, shortly thereafter resigning from the Federal Reserve.

Walsh further believes that the Federal Reserve's active use of its balance sheet may have ushered in a "monetary-dominant" period. He argues that by artificially keeping interest rates low for an extended period, the Federal Reserve played a leading role in facilitating the accumulation of U.S. government debt.

Walsh's Criticism of Other Policies

Aside from the balance sheet, Walsh has also criticized the Federal Reserve on multiple fronts.

For example, he believes that the Federal Reserve relies too heavily on data and lacks foresight, while also criticizing the routine use of forward guidance by the Federal Reserve. He recently pointed out:

Forward guidance, a tool that was prominently introduced during the financial crisis, has little effect during normal times.

Walsh also questions other aspects of the Federal Reserve's formulation and interpretation of monetary policy, including the erroneous belief that: "monetary policy is unrelated to money," "black box DSGE models are grounded in reality," and "Putin and the pandemic are to blame for inflation, rather than government spending and the surge in money printing."

The report analyzes that these criticisms imply that Walsh hopes for greater attention to the size of the Federal Reserve's balance sheet and money supply in the execution of monetary policy, and may advocate for a comprehensive reform of the Federal Reserve's research team.

Finally, while he describes the independence of the Federal Reserve as a "valuable" endeavor, he also believes that the Federal Reserve itself has invited questions about its independence. Walsh points out:

The Federal Reserve's oversized role and poor performance have undermined the important and valuable rationale for the independence of monetary policy.

Additionally, Walsh condemns the Federal Reserve's mission creep, including considerations of issues such as climate and inclusivity.

Recent Policy Impact Outlook

Although Walsh has recently advocated for lowering interest rates, Deutsche Bank believes he is structurally not dovish.

His views during his tenure as a governor during the global financial crisis were sometimes more hawkish than his colleagues, particularly on the issue of the balance sheet. Recently, he expressed opposition to the Federal Reserve's decision to cut rates by 50 basis points last September.

In terms of policy decision-making, Walsh's recent statements indicate that he may support lowering the policy interest rate, although this move may come at the cost of a reduction in the size of the bank's balance sheet.

However, given that reserves are at adequate levels and the Federal Reserve has recently restarted its reserve management purchase program, this trade-off is only feasible if regulatory reforms reduce banks' reserve requirements.

While several Federal Reserve officials, including Vice Chair Bowman and Governor Mulan, have recently made this argument, it is unclear whether these changes are realistic in the short term.

The research report concludes that, from a more macro perspective, regardless of whom President Trump chooses, the market may test the independence of the next Federal Reserve Chair and the credibility of their commitment to achieving inflation targets.

Deutsche Bank emphasizes that the new chair will always need to earn this trust. Given the context of Trump's demand for significant interest rate cuts from the Federal Reserve, this demand may be even more urgentTherefore, Deutsche Bank is skeptical about whether there will be substantial changes in policy after the leadership transition at the Federal Reserve in June, especially since the new chair only has one vote in a particularly divided committee.

This means that investors should not expect a sharp turn in Federal Reserve policy immediately after the new chair takes office, and the market needs to prepare for a gradual policy adjustment process