Fed Chair Warsh Emphasizes Independence, Signals Market Relief on Inflation

Warsh: "Lower Inflation Expectations"
U.S. Treasury Yields and Dollar Decline
Fed Reiterates Need to Reduce Balance Sheet

Federal Reserve (Fed) Chair Kevin Warsh reaffirmed the central bank’s independence and its 2% inflation target. However, his assessment that inflation expectations have recently declined led to a partial easing of market concerns regarding future benchmark interest rate hikes.

Warsh also reiterated his previous stance that the Fed’s balance sheet needs to be reduced. However, he indicated that any actual reduction would be carried out only after a significant period of preparation and would take place over a long time.

On July 1 (local time), Warsh attended the European Central Bank (ECB) Central Banking Forum in Sintra, Portugal, and stated, “We have long been an independent central bank, we remain an independent central bank, and there will be no change to that.” He emphasized that decisions on monetary policy would remain free from political pressure, even as U.S. President Donald Trump has pushed for rate cuts.

He also made it clear that he would not retreat from the Fed’s 2% inflation target. Warsh said, “Anyone who thought the central bank would be satisfied with an inflation target above 2% will be disappointed,” adding, “We will achieve price stability.” Regarding current price levels, he noted, “If you look around, you can see that prices are too high.”

However, Warsh assessed that the inflation environment has somewhat improved over the past month. He stated, “Over the last four weeks, inflation expectations have decreased, and inflation risks have also declined.” This can be interpreted as reflecting the stabilization of international oil prices, as the United States and Iran have entered a truce phase, which is now influencing inflation forecasts.

Regarding the impact of rising oil prices during the war on the economy, he said, “It can be observed on the demand side in the short term,” but added, “It is up to the central bank to determine whether that is inflationary.” He continued, “We need to see whether the impact spreads across a broad range of goods.”

Market Relieved After “Lower Inflation Expectations” Comment... U.S. Treasury Yields and Dollar Fall

The market became somewhat relieved following Warsh’s remarks. According to the Financial Times (FT), after Warsh mentioned a reduction in inflation risks, U.S. Treasury yields and the dollar fell. The yield on the U.S. two-year Treasury note, which is highly sensitive to rate outlooks, dropped by 0.03 percentage points to 4.14% that day.

Mike Lorizio, Head of U.S. Rates and Mortgage Trading at Manulife Investment Management, told the FT, “Warsh’s comments on productivity improvements and easing inflationary pressures were interpreted by the market as dovish (favoring monetary easing).”

According to the FT, the market at one time did not expect a rate hike until March 2027, but recently, it is even factoring in the possibility of a rate increase as early as this October. However, when asked whether he was signaling the possibility of a rate hike at the upcoming Federal Open Market Committee (FOMC) meeting on July 28-29, Warsh declined to answer.

He said, “I hope we have a good ‘family-style intense discussion’ when we meet in four weeks,” and added, “Once we enter the meeting room and close the door, we will have a good discussion, but there isn’t much more I can say right now.”

This is also consistent with Warsh’s emphasis on reducing ‘forward guidance.’ He has maintained that the Fed should not guide the market in advance on the future rate path, but instead make decisions at each meeting based on economic indicators and financial conditions.

Emphasizing Again the Need to Reduce the Balance Sheet

Federal Reserve (Fed). Reuters Yonhap News

Warsh again stressed the need to reduce the Fed’s balance sheet. According to Bloomberg, he said, “It took about 18 years to reach a balance sheet of this size,” adding, “It will take much longer than 18 weeks to reduce it to an appropriate size.” He also stated that the Fed’s balance sheet is now “close to the realm of fiscal policy,” and emphasized that interest rates should be the main tool for conducting monetary policy.

The Fed’s balance sheet expanded rapidly during the global financial crisis and the COVID-19 pandemic. According to Bloomberg, the Fed’s assets increased from less than $900 billion in 2007 to about $9 trillion by June 2022.

Although it has been partially reduced through quantitative tightening, the Fed still holds a massive asset portfolio in the upper $6 trillion range. However, Wall Street believes that even though Warsh reaffirmed his commitment to reducing the balance sheet, it will still take time before it is actually implemented.

Bloomberg reported that Wall Street now expects further balance sheet reductions to be possible only after 2027, in light of Warsh’s remarks. CIBC strategists expect the Fed to announce plans for balance sheet reduction by the end of this year, gather public comments through the second quarter of next year, and begin full-scale reduction in the fourth quarter of 2027.

There is also significant concern in the market about balance sheet reduction. As the Fed reduces its assets, reserves within the financial system also decrease. Many strategists believe that the financial system is now structurally reliant on a larger level of reserves than in the past, and that a rapid reduction of the balance sheet could trigger instability in short-term funding markets.

Samuel Earl, a strategist at Barclays, told Bloomberg, “The risk of moving toward scarcity far outweighs the benefits,” adding, “It could potentially shake up the repo market.”

This content was produced with the assistance of AI translation services.