The biggest mistake Warsh could make

By Desmond Lachman

When US President Donald Trump named Kevin Warsh as his nominee to take over as US Federal Reserve Chair after Jerome Powell’s term ends in May, markets breathed a sigh of relief. But Warsh is set to confront two major monetary-policy challenges, only one of which he appears likely to handle well.

The first challenge is the rapidly accelerating AI revolution. AI is on track to increase labor productivity significantly and weaken labor demand – trends that, together, will put downward pressure on both wages and prices. Already, major firms, such as Amazon, are shedding workers, and entry-level jobs are becoming increasingly scarce. While this raises challenges for the economy, it also offers the Fed an opportunity to guide it onto a higher growth path and to bring inflation down to its 2% target.

Judging by his comments to date, Warsh appears to be better qualified than Powell to respond effectively to the AI revolution. Whereas Powell’s data-driven approach to monetary policy is fundamentally backward-looking, Warsh argues that the Fed should try to anticipate structural economic change, as former Fed Chair Alan Greenspan anticipated the productivity surge brought about by the internet revolution in the 1990s. This suggests that Warsh will promote a monetary-policy stance that does not hamper the coming AI productivity boom.

Unfortunately, Warsh may not be as well equipped to confront the second major challenge he is likely to face as Fed chair: a financial crisis that begins in the bond market. If there is one thing that Warsh has consistently railed against, it is the Fed’s use of quantitative easing to deal with financial crises and to stimulate the economy. He argues that the Fed’s bloated balance sheet, which now stands at over $6.5 trillion, has distorted financial markets and encouraged fiscal profligacy by signaling that boundless money creation is acceptable.

Warsh believes that reducing the size of the Fed’s balance sheet will allow for lower short-term interest rates – something that Trump has aggressively advocated – without compromising the Fed’s 2% inflation target. What Warsh does not acknowledge is that any attempt to reduce the size of the Fed’s balance sheet will increase the risk of a bond-market crisis.

That risk is already acute. The US government is now running an annual budget deficit of close to $2 trillion (more than 6% of GDP), and it needs to roll over around $9 trillion in maturing debt this year. Meanwhile, foreign investors – who currently hold $9.4 trillion in US Treasuries, 30% of the total – are increasingly reluctant to roll over their Treasury holdings. What was once viewed as a safe-haven asset has had its credibility undermined by Trump’s erratic and antagonistic behavior, including his weaponization of finance. Fears that the US might try to inflate away its massive debts are intensifying.

The market signals are as worrying as they are undeniable. Over the past six months, the all-important ten-year Treasury bond yield has increased to nearly 4.3%, even though the Fed has cut its policy rate. Not even the fact that Treasury Secretary Scott Bessent is now funding the government largely at the short end of the curve has been enough to reverse this trend. Meanwhile, the dollar has lost more than 10% of its value over the past year, and gold prices have approximately doubled, reaching a record high of almost $5,595 per ounce last Thursday.

Notably, gold fell 10%, and the dollar rose slightly, the following day – right after Warsh’s nomination was announced. Perhaps markets were relieved that, despite his relentless attacks on the Fed’s independence and fury at Powell’s refusal to slash the policy rate, Trump ended up selecting a conventional candidate.

Whether markets’ faith turns out to be well founded depends significantly on how Warsh handles rising bond-market risk. With foreign investors losing confidence in the US economy, the last thing the bond market needs is for the Fed to increase pressure on long-term yields by attempting to reduce its Treasury holdings. While reining in the Fed’s balance sheet is a worthy long-run monetary-policy goal, now is not the time to pursue it.

Desmond Lachman, a senior fellow at the American Enterprise Institute, is a former deputy director of the International Monetary Fund’s Policy Development and Review Department and a former chief emerging-market economic strategist at Salomon Smith Barney.

Copyright: Project Syndicate, 2026.
www.project-syndicate.org

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