Warsh’s take on Fed independence is met with confusion, concern

Most people don’t know and don’t have much reason to care what a currency swap line is, except that the financial instrument could soon help markets understand what Federal Reserve Chair nominee Kevin Warsh’s unique ideas about Fed independence really mean.

Warsh has said categorically the Fed should be “strictly independent” in the making of monetary policy. But he adds that he’s willing to work with Congress and the Trump administration on “non-monetary matters.”

In answers to senators’ questions following his April 21 confirmation hearing, he elaborated: “Fed officials are not entitled to the same special deference in areas affecting international finance, among other matters.”

Warsh has also talked often about a new “Fed/Treasury accord” that he’s suggested could govern the Fed’s balance sheet, though in ways he has yet to detail.

To six former Fed officials interviewed for this article, those comments were unclear or confusing at best. When it comes to Fed independence, they found his analysis worrisome at worst. The outcomes could be benign, tinkering around the edges of existing conventions, or more concerning limitations to the Fed’s ability to use its balance sheet in a crisis. Because of the lack of clarity in Warsh’s comments, none of the former officials who spoke with CNBC were ready yet to draw conclusions either way.

Former Richmond Fed President Jeffrey Lacker, long a hawk on interest rate and balance sheet policy, said he could welcome a new accord between the Fed and Treasury Department if it led to the Fed focusing on monetary policy, leaving credit policy up to Treasury. Under such an accord, for example, the Fed could be limited to just buying treasurys, not mortgages or other financial instruments.

But Lacker added, “I can also imagine a less constructive agreement that lets the Treasury use the Fed’s balance sheet to bypass Congress, perpetuating bad practices and compromising the Fed’s independence.”

One former high-level Fed official, who spoke on condition of anonymity to speak candidly, said, “If followed to its logical conclusion, the Fed could lose control of its balance sheet.”

Warsh’s views on what is and isn’t monetary policy aren’t fully clear. He may elaborate once confirmed by the Senate, but for now has left lawyers, economists and Fed observers to parse cryptic comments like those in his Senate responses.

Warsh declined to comment for this article.

One challenge facing Fed observers is that the difference between monetary and non-monetary functions at the central bank can be less than clear.

Swap lines occupy that gray area, several former Fed officials said. Used mostly during financial crises, the Fed gives dollars to another country’s central bank and receives an equal amount of the foreign bank’s currency in return. Fed officials see these arrangements as providing dollar liquidity in foreign markets to prevent or lessen a scramble for dollars abroad that could infect U.S. markets.

Treasury Secretary Scott Bessent recently said that several countries in the Persian Gulf have requested swap lines, including the United Arab Emirates. Treasury could provide those swap lines, as it did recently to Argentina, using Treasury’s own funds. But what’s unclear is whether Bessent wants the Fed to provide them. The senators in their written questions asked Warsh if he believed the Fed would be required to accede to the Treasury’s wishes, but he didn’t directly answer.

To former Fed officials, swap lines can be thought of as monetary policy, at least in part. The first clue is that they must be approved by the Federal Open Market Committee, the group that charged with setting monetary policy. Second, the provision of dollars to foreign central banks increases the balance sheet when the swap lines are drawn on. In the Great Financial Crisis, swap lines added almost $600 billion to the Fed’s balance sheet for a brief time, or 25% of the Fed’s balance sheet at the time, according to data from Haver Analytics. During the covid-19 pandemic, swap lines reached a maximum of $450 billion.

Warsh’s comments may not amount to any immediate changes in policy. In practice, in moments of crisis, the Fed and Treasury work together to address market chaos. That was true when Warsh worked as a Fed governor during the 2007-2008 crisis. But the decision remains the Fed’s, and the rationale has nearly always been a systemically significant disruption in dollar liquidity.

“In the worst outcome,” said another former Fed official, who also spoke on condition of anonymity to speak candidly, “the Fed’s balance sheet becomes an arm of foreign aid.”

That is the potential danger with swap lines for the UAE and other Gulf nations. Those countries don’t seem to need them to ward off a dollar liquidity crisis, so providing them may look like a political judgment rather than a question of whether markets need them to function.

Even if there were a liquidity problem in the Gulf countries, there is no sense of a dollar funding problem in the U.S. right now. The UAE is a wealthy nation, with considerable reserves and sovereign wealth funds. At the same time, the administration has ample reason to help an ally in the middle of the Iran war. A dollar swap line, several officials said, would give the UAE the international cachet normally reserved for G-7 and other major, developed countries.

Warsh is also hinting at changes that could affect much bigger parts of the central bank’s operations. The revised Treasury-Fed accord Warsh envisions would in some, still-unspecified, way govern the size and potentially composition of the Fed’s balance sheet. That suggests Warsh doesn’t see balance sheet policy as integral to monetary policy as do other Fed officials. Again, it’s unclear exactly what Warsh means by this accord. But the decision to buy or sell assets requires a majority vote of the FOMC, a sign that it is ultimately a monetary policy decision.

Both Warsh and Bessent have criticized the Fed’s bloated balance sheet outside of times of crisis. In fact, it was Warsh’s objection to the Fed’s decision not to reduce its balance sheet in the wake of the Great Recession that led him to resign as governor in 2011.

Bessent has compared the Fed’s growing balance sheet to a dangerous lab experiment. He calls it “gain of function,” saying it increases the Fed’s footprint in the economy and gives it power that should rightly be seated in the Treasury and the administration.

“I think that, especially during the GFC, a lot of things moved from Treasury to the Fed that are political decisions that should be the at Treasury,” Bessent told CNBC on April 14 when asked about Warsh’s idea. “So we’re in agreement on that.”

But Bessent didn’t elaborate on precisely where he agreed with Warsh. “I’m not sure exactly what he means about the Treasury-Fed accord,” he said.

Lacker is among those who have criticized the Fed’s creep into “credit policy,” which he defined as the Fed buying anything other than treasurys. The Fed began purchasing mortgages during the Great Recession and even ventured into corporate bond purchases during the pandemic.

The Warsh idea of a Treasury/Fed accord could limit the Fed to buying only treasurys.

But a Treasury/Fed accord could limit the Fed’s ability to use its balance sheet if, for example, the agreement requires the Fed to get Treasury permission to buy assets and the type of assets it could buy.

“The challenge is if we have a severe crisis and fiscal policy doesn’t respond quickly,” said former Boston Fed President Eric Rosengren. “The flexibility that monetary policy provides is hamstrung” if the Fed agrees to limits on the size and composition of the balance sheet and needs permission to act.

Rosengren recalled that one reason the Fed bought mortgages was that it risked becoming too large a player in certain parts of the treasury market.

In a report on Friday, JP Morgan’s chief U.S. economist Michael Feroli, wrote, “most Fed officials see balance sheet policy as just interest rate policy by other means when the short rate is constrained by being close to zero.”

A bigger concern for the former Fed officials would be if Treasury could order the central bank to purchase a certain amount or type of asset. That loss of independence could spook bond markets since it could be seen as the Fed financing the deficit or allocating credit to certain sectors preferred by politicians — actions it has already been accused of taking through its various asset purchases. It could also be seen as the equivalent of the Treasury ordering the Fed to ease policy.

Former St. Louis Fed President Jim Bullard said the idea of the Fed and Treasury cooperating to limit what the Fed can buy has long been discussed. He agreed with Bessent’s criticism that the Fed loads up on assets during a crisis and never really winds them down. But he said other comments by Bessent sound like “he’s talking about intimate cooperation. That’s usually associated with bad outcomes.”

Warsh’s views on the potential relationship between the Fed and Treasury could be more conventional. Already, it is common practice — though one not without its critics — for the Fed to follow the administration’s lead on bank supervision policy. Under President Joe Biden, it began to consider the financial cost of climate risk among the banks it regulated. It dropped that when President Donald Trump won reelection. But it has since embarked on a process of reducing the regulatory burden on banks, in line with the administration’s policy goals.

A reason for these political swings is that the Fed makes regulatory policy together with other agencies headed by political appointees.

And when it comes to dollar policy, the Fed has long conceded that is the purview of Treasury.

JPMorgan points out that reducing the balance sheet could have some support on the FOMC but would take time.

“The other 11 members of the FOMC will act as a brake on any quick shift in monetary policy under Warsh,” Feroli said.

Warsh may believe that by pre-emptively shedding all those other responsibilities, he can ensure the Fed’s core business of setting interest rates remains independent and can never be called into question — even by the president who nominated him.

He hinted at that view at his nomination hearing. “Presidents want lower rates, but Fed independence up to the Fed,” Warsh said.