Will Trump's New Fed Chair Crash Markets? | Joseph Wang

I kind of get the sense that the Federal Reserve is the last bastion of the resistance. The president is quoted as joking that if you don't cut rates, I'm going to sue you. So, we can say that we're going to get rate cuts, right?

What Walsh is different is that he wanted to have a smaller balance sheet. By itself, shrinking the balance sheet would be risk negative. My base case is it's not easy to shrink this without having an impact on risk markets, but there is a path towards this.

Central bank independence is really a new thing. It seems like we're just going back to an older system that has prevailed for most of history. And so accountability for inflation is going to have to be through the ballot box.

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All right, everybody. Welcome back to another episode of Forward Guidance. And joining me this week is Joseph Wang of fedgu.com. And could not have asked for a better guest for this week. We had a lot of action on the Fed late last week. We finally got the formal announcement of the new Fed chair that Trump has decided on and it's Kevin Wars. So, Joseph, great to have you on the show.

Thanks for inviting me. It's great to be back as always.

And before we get into things, I do want to give a little shout out that if you do enjoy this conversation over the next hour, we're going to be doing it again live in person at the Digital Asset Summit in New York March 24th to 26. Going to be a ton of fun. We'll be doing a Ford guidance roundup live and a whole bunch of different specific Ford guidance panels of which Joseph will be a part of one of those. So, we'll have the link in the description. Check it out. Get your tickets. Going to be a ton of fun. Joseph. All right, Kevin Walsh, that is our nominee for the Fed. What's your take?

Wow.

It was kind of surprising because of all the potential nominees, Kevin Walsh was obviously the most hawkish, right? So we know a lot about Kevin Walsh because he used to be a Fed governor and in retrospect all those meeting minutes were declassified and we also have a really long public record of him commenting on monetary policy giving presentations writing opeds and so forth and he's really just been singing the same tune for over a decade now.

Just for some context like heading into the great financial crisis Kevin Walsh was all about the financial system was great by the way we should be worried about inflation After the financial crisis in 2008, the unemployment rate around 10%, Kevin Worsh was like, "Yeah, that's not good, but hey, we should be worried about inflation."

And so, he's someone has consistently exhibited not very good judgment on monetary policy, but also consistently been quite hawkish. From his perspective, he seems to have more of a montorist view of the world. And so when he sees the Fed expanding their balance sheet, increasing the money supply and so forth, he's been afraid of inflation.

That was totally reasonable back after the great financial crisis. Many people were concerned about that. You saw the price of gold surge and many prominent commentators come and say, "Whoa, the US is basically monetizing the debt. We're going to have hyperinflation or things are going to go really bad and so forth."

That was a reasonable mental model, but that just didn't happen. And year after year after year, the Fed actually had trouble meeting its inflation target. So, we know that's not a correct mental model, but Kevin War seems to still have that anyway.

So, what we've seen is that Kev the the nomination of Kevin is basically from a policy standpoint, his finally has the opportunity to realize his career quest of shrinking the Fed's balance sheet. Now, Wash is also promising rate cuts.

I think there's an article from the Wall Street Journal, where the president is quoted as joking that if you don't cut rates, I'm going to sue you. So, we can say that we can get rate cuts, right?

The argument is obviously not because the president said so, but because, and this is a standard dovish argument today, is that the labor market, you know, not doing that great. And also we have this huge productivity boom which based on official data it does look like we do have an increase in productivity and that is going to allow us to cut rates because that's this inflationary.

Okay. All the Fed nominees would have given the president that. What Walsh is different is that he wants to have a smaller balance sheet. Now there's a lot of discussion in the market as to whether he can actually do this.

Because we all know the president loves the stock market. He also likes lower rates and so forth. So, you know, strengthening the Fed's balance sheet that doesn't seem to jive with that. But I will also point out that having a smaller Fed balance sheet is actually a consensus position in the Trump administration.

Now, Secretary Bessant, like the the top official when it comes to economic policy, had a very memorable column last year about the gain and function monetary policy and so forth conducted at the Fed, really lambasting a large Fed balance sheet. And then you also had Governor Bowman, Governor Myron, and also recently Kevin Hasset come out and just all endorse a smaller Fed balance sheet.

So I think this is something that they do want to do. It's not going to be one of those things that they, you know, save to campaign and then change their mind. So I think this is going to be the most interesting topic from a from a war nominee perspective.

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Yeah, that's a that's a great overview. Tons of different points I wanna I want to deep dive into over the next hour, but I actually want to start with, you know, sorting out basically this proposition that that Worsh had back in in '08 onwards about how QE was in inflationary basically and that was really the the baseline foundation of a lot of of his perspectives.

So you've you've written a lot about the mechanics between how QE actually works in your in your book central banking 101. And I think it's it's a really important book to read, especially as we're going to get into the discussions.

And there it is. Boom. Mag 101. New version coming out soon. There we go. You heard it here first. Maybe not. You didn't hear it first, but you heard it here anyway. Um, okay. So, walk us through like your perspective on how to think about quantitative easing in terms of its in impact on the economy in terms of do you agree that it could be inflationary? because obviously we had a lot of we had a lot of QE happening in the 2010s and we had zero inflation and that's really the bedrock of of why Kevin Worsh's thesis was so incorrect in in the late 2000s. So yeah, walk me through how to think about that.

So I would even go earlier than 2008. So there's a school of thought in macro called monitoriism where they place huge emphasis on the money supply in determining a level of prices in the economy. This was popularized by a lot of people in in the 1980s 70s and so forth. Notably Milton Friedman note is quoted as saying inflation is always and everywhere a monetary phenomenon and that was you know a very very compelling mental model.

Obviously, right? You print a whole lot of money, prices are going to go up, right? So, everyone really kind of bought into it because it was just made so much sense. In in fact, in the 1980s, the Fed actually went to targeting the money supply as one of its policy implementation measures rather than controlling interest rates. And in order to track all this money supply stuff, they invented, you know, MT, M2, M3, even M4. And that stuff was later discontinued. And the Fed also discontinued targeting the money supply because they realized that it doesn't work from one way to think about it is that the velocity of money was something that was time varying and so just changing the quantity of money just didn't really get them the economic outcomes.

Now, fast forward to 2008. Again, when the Fed is doing quantitative easing, you also have this very seductive mental model come out and saying, gosh, the Fed is printing a lot of money. Obviously, we're going to have high inflation. But again, that did not happen. It didn't happen when the Bank of Japan did it, and it did not happen when the ECB doing did it.

I think what people are misunderstanding when it comes to quantitative easing is that yes, the Fed absolutely prints a lot of money, but it's also important to realize what they do with that money. So they print out a whole lot of money and then they take that and they go and they buy a whole bunch of treasuries, right? So they're not buying goods and services, they're buying treasury securities.

It's like a huge swap with very liquid assets, cash-like assets, and in exchange taking out treasuries from the financial system. Now, you flip it around and you look at this from a private investor standpoint. Let's say that Felix, you have a million dollars in treasuries in your trading account and then you sell that and you get a million dollars in deposits. You don't have any more purchasing power at all.

Right? Fed printed a lot of money, but you know, you don't really it doesn't increase the purchasing power of the private sector. It just inc it just changes the composition of their assets. Fewer treasuries, more liquid cash-like assets. And so, what are you going to do with those that million dollars in cash you have, you know, maybe you go and you buy corporate debt, maybe you go and you buy equities, or maybe you just leave it there.

So, what Kiwi really did was exactly what Berneni intended it to do. push up the prices of treasuries and that is to say lower longer interest rates and maybe have a bit of a wealth effect the goose financial markets. So that really I think it was just a misunderstanding about Kiwi that kind of led to a lot of people concerned about inflation but in the end it worked exactly as as Bernanki intended it to do.

So, so to that end, I think yeah, there's this important distinction between, you know, I've heard Michael House described this before as like financial inflation and main street inflation as as as separate things. And QE worked really well at financial asset inflation. And, you know, during this era of QE, we just seen all financial assets head higher, but we never really saw the the main street inflation follow through.

And I'm curious, it's interesting about you mentioned earlier about how most of the Trump administration is has this perspective on wanting to get out of the game of QE and balance sheet manipulation effectively um or as as Secretary Bessin called it in his op-ed gain a function of of of Fed policy and I'm just curious like how much of that perspective do you think is is valid like and why do you think they're pushing it so hard?

Because in the same vein, you also have Trump talking about he really anchors his success as a president to the stock market going up. So you would imagine that okay, well Kiwi is really great because it's probably going to make financial assets going to go up, which is going to make him happy because the stock market is going up.

So by itself, shrinking the balance sheet would be risk negative, but there are tools that the the administration can do to make it uh less impactful or or maybe not not even that impactful at all. So there's a lot of moving parts to how shrinking the balance sheet can be done. My base case is it's not easy to shrink this without having an impact on risk markets but but there is a path towards this.

My best guess is that the administration is distrustful of the Federal Reserve and so seeing its enormous power through its balance sheet and so forth makes it uneasy. Again, looking just more broadly at the United States government, I kind of get the sense that the Federal Reserve is kind of the last bastion of the resistance, quote unquote, whereas all the other government agencies kind of bent the knee, but you have J. Pow there kind of being somewhat defiant, of the president. And so I think that makes makes the administration less comfortable with the Fed and would prefer that they have less influence.

You actually mentioned in in a piece you put out this morning about how the balance sheet as a percentage of GDP these days basically like since post especially lately you know we're we're somewhere around the world of of 20 25% of of GDP I think is what you mentioned and you know we we did live in an era of like a 5% of GDP is what you mentioned in the piece there like pre8 preq the more scarce reserve regime that the Fed operated in it worked We we we have example we have empirical evidence of it actually working but now we're in this world of of ample reserve regimes and I'm just curious if you could walk through to the audience like what would it look like because right now you know we went through QT we got to a point where it's it would be really difficult for us to really decrease the amount of reserves in the system without us entering that potential scarce reserve regime.

So I'm just curious if you could walk through what that what that would look like to get to that point of where we were pre8 and how feasible it is to actually get there.

So like you mentioned pre8 for for like 50 years pre-08 we were in a scarce reserve regime where the Fed's balance sheet was about 5% of GDP. So the way that I look at it is that at the end of the day the central bank and the commercial banking system have elastic balance sheets. What that means is they could create credit out of thin air and go and provide liquidity to the non-banks sectors.

Now pre great financial crisis it was largely the commercial banks that were expanding their balance sheet so creating credit providing liquidity making loans to to the private sector to the more private markets. During 2008 though they the the regulators began to think that okay after the 2008 financial crisis the regulators realized that that was not a good idea because when the banks extend credit and lend to each other and so forth they there's a lot of potential contagion risk where you have counterparty risk where let's say you lend to a bank and then the bank fails and then there's a digitizing effect whereas the bank that lent that money also maybe we'll have some credit problems and so forth and then since everything is so interconnected you could have a huge run on the banking sector and have that bleed into other financial sectors which is exactly what happened.

So the decision was that instead of banks holding liquidity within the banking system. So let's say that if you were banking you had liquidity you would store it say in the federal funds market where you lend it to another bank. you would instead sore all your liquidity as a deposit at the Federal Reserve. We call that reserves.

So instead the official sector, the Fed expanded its balance sheet and began to provide the liquidity that the private sector needed. And the banks in turn after because of regulation leverage ratio for example, but also much higher risk metrics became much more constrained in its ability to expand their balance sheet. And so basically it was a handoff from the private banking sector having the flexibility to meet the liquidity needs of the economy to more of the Fed.

And now they're trying to reverse that by first reducing a little bit of the regulations that have been binding the commercial banks for example the SLR and then hopefully smoothly transitioning from a smaller Fed and back to a private more private bank centered way of adding offering liquidity to to the private sector similar to how it was pre209.

Do you do you have an opinion on which system is better? Obviously, you know, it feels like the recency bias makes us think that the the ample reserve regime we've been in where commercial private banks have just refused to issue loans and take on risk basically over the last 10 years either because of you know risk based ratios like you just mentioned stopping them from two but also just the hang-ups associated with with '08 and what happened there and and DoddFrank and and Bosel 3 regulations all that stuff like if do you have an opinion on which system is is quote unquote better for however you want to define what better even looks like.

Well, you can I mean that just kind of you can just shift to the definition to make it whatever better. So I I think that either could work. It's just that um I mean so there are a lot of moving parts to to any kind of system and how you design it and you could always design either either system to make it so that um it could work well.

I guess what looking back over the past decade of just having a large Fed balance sheet, I think what we've what I've come to realize and I think many people as well, it there just doesn't seem to be any downside in having a large Fed balance sheet. What happens is that the banks basically have a ton of cash and so there's really no liquidity problems for the banking sector. And that's that's that's a really a good thing, right?

So, it's possible that you could overdo it, but at the end of the day, it does make the banking system safer. You could probably have the same kind of safety in a small Fed, bigger banking system scenario, but you'd also need more regulation so you won't have a repeat of what happened in 2008. And maybe you need to have more emergency Fed facilities, whereas banks could more easily access in an unstigmatized way facilities like the discount window or others like it like uh the repo facility or something like that. So either could work. um you just have to add enough parameters to make them optimal.

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Yeah, I guess that that brings up the question of what will actually happen once wars in the chair confirmed about what's realistic because it's it's quite easy to to be on the outside and and criticize these ideas of excessive balance sheet use, but once you're actually in the chair and you have to make these decisions and you know, I'm sure Kevin Worch is an exceptionally smart person, intelligent person. And I'm sure he has the the cognitive ability to reflect on the last decade and see that some of his views in in 2010 didn't really pan out. We didn't get the hyperinflation from QE. And I'm sure he's self-aware of that. I would be very surprised if he wasn't.

So I'm curious like the way I've been thinking about it is once he gets in the chair, I I'm doubtful for us to see much more unwind of the balance sheet. Maybe a little bit like there is some levers that can be pulled. Um, but to me the the tail that's getting cut here is the possibility for the Fed put or further QE if you know the the threshold that would need to be met before the Fed chair decides to go guns blazing with QE again feels like it's going to be a lot higher now. Do you do you agree with that framework?

You're saying that there we we could have a higher probability of expanding the balance sheet because of some u hiccups in the financial markets and that's not appreciated.

Well, I'm saying that it the probabil like the threshold we would need to meet is much higher before we get that like during PAL probably if if whatever happened and the markets went down 10% much higher odds of QE occurring under war that probability is probably a lot lower now like the threshold that needs to be met to to turn on the taps and get QE going feels like that threshold is much larger now maybe that's why yeah I think so one thing to note is that QE has always been and this is a consensus position something you roll out when interest rates are at zero.

Now interest rates today are far above zero and so before we get proper QE like the Fed buying longerdated bonds more duration it it's going to you going to have to cut the policy rate down to towards zero first and at the moment that seems like it's a bit of a stretch but that also gives a war should he want to shrink the Fed's balance sheet a lot of leeway to counteract any of the financial tightening that that could arrive if we he continues to shrink the balance sheet. So there there is a lot of cushion for him to do that.

Now one thing I'll note is that so the Fed we all know jealously guards its independence right but for that though it's really just its interest rate policy whether or not to hike or cut rates can see that they willing to go to court to protect that. But u that's not all the Fed does and the the consensus has been that for example when it comes to regulatory policy the executive gets to decide that. So the custom has been that when you have a new president, the vice chair of supervision at the Fed steps down and so the Fed so the new president can appoint someone else and that person right now is uh Mickey Bowman.

And so regulatory policy is not something that the Fed has independence in. And something else and this is of course this is a new thing is that we can consider whether or not the Fed has independence in how it implements monetary policy because at the moment you're implementing it in a you know abundant reserve framework. Sounds like Wash would like to implement it with a scarce reserve framework. You're not really impinging upon Fed's independence. You're really just changing how it implements.

Now, if you have a treasury who wants to do this and you have enough Bedford board members, I suspect that this is something that can be done uh without anybody uh crying about fan independents and so forth should should they decide to do this.

Yeah, I think that's the next big theme to discuss here is something that that War has written on which is this idea of a new Treasury Fed accord. Um and and and we've also seen a lot of commentary across the board from from Trump nominees. You know, we had Fed Governor Steven Ron has mentioned this too, which is that, hey, look, like we're in this era where there's less independence from the Fed and and more cooperation between the Treasury and the Fed. Let's just call a spade a spade and actually create a regulatory framework around that and move forward instead of just pretending that doesn't exist.

And I'm just curious about your perspective of of what does that Fed Treasury Accord actually potentially look like if if Wars can get through what he wants to to do at the Fed?

So at the moment just based on what they're saying is that now Treasury will be the will be the organization that manages the duration of public sector liabilities. So for example let's say that the the Treasury issued a whole bunch of 10 years. So that means the private sector has has to absorb those 10-year Treasury securities. But if the Fed were just independently decide to just buy all those then what that means is that the private sector doesn't have anymore. Instead, the private sector is holding reserves which are, you know, zero duration public sector liabilities.

So, in effect, the Fed was controlling just how much interest rate risk the private sector was holding. And well, now they now if we have a smaller Fed balance sheet, they're not doing that anymore. But to your broader point though, I I do agree that their ultimate plan is to have more of an industrial policy kind of coordinated setting where the central bank basically finances the government.

This is actually super common throughout history. So for example, in Japan during the 1980s when they were industrializing and booming, the Bank of Japan was was not independent. they they basically you know just kind of implemented industrial policy maybe offering loans to industries that were favored for example uh to try to spur growth. It was only after 1998 I believe until the bank of Japan was independent and this is actually pretty common to uh western European countries as well. The Bank of England, Bank of France were not independent until the 1990s.

So central bank independence is uh really a new thing. It seems like we're just going back to an an older system that has actually prevailed for I'd say most of most of history where uh the central bank uh is kind of the junior partner to the to the uh to the rest of the government. And so accountability for inflation is going to have to be through the ballot box. So maybe you could kind of see this happening let's say in Argentina or even just 2024, right? inflation was not popular and uh the incumbent political party lost.

That that's a wild idea that yeah, inflation is through the ballot box. And I I'm curious about how you think the market would would digest that and specifically either long-term interest rates as well as uh swap spreads, term premiums, these these metrics that would reflect a bit more of this long-term perspective on on the impact of of Fed independence. like if if we move toward this world of of less Fed independence, how would you see that be impacted in those in those market rates?

Well, first off, I want to say hit the obvious. Obviously, the market is is not going to implode, right? Like I just said, like central bank independence is a relatively new thing. So, you know, you think about, you know, France, think about uh the UK, think about Japan, 1980s and 1990s. all that time for all those centuries you don't have there on markets implode because your central bank is not dependent okay so that that's obviously nonsense so I think of longer dated rates as largely the expected path of fed policy but you also have uncertainty as to that policy so you have some term premium and but you also just basic uh balance sheet costs and holding that and that would be uh swap spreads right so if we have a central central bank that is less independent.

I think first off obviously the path of policy is going to be lower, right? Because the government always wants to have a lower interest rates. At least this government in the US does. That's kind of crystal clear. So you have to have a lower path of policy. However, you're doing something new now. You will have people who are afraid that maybe lower rates implies higher inflation.

And so you're going to have them also try to guess whether or not there really is the political willingness to keep rates this low. So you'll have higher term premium. And I also think as regulations get into effect, you will have wider swap spreads. So swap spreads become less negative. So the balance sheet cost of holding treasuries declines. Put that all together, I still think that a lower policy rate outweighs all of this other stuff and we'll get a lower uh lower longer interest rates.

Oh, just as an aside, because I I hear this so often, it kind of surprises me. So, oftentimes I I hear that, you know, the Fed is going to keep rates too low and that's going to cause inflation to accelerate and so that's why it's bad for the bond market. Now, aside from the fact that that's not necessarily how longer term rates are determined, but there's kind of no reason to think that would actually be h have caused inflation to roar back because if you think back the past two decades, right? So after the great financial crisis, interest rates were at zero. In some countries, they were negative. You had central banks all over the world buying trillions in bonds and you had no inflation every anywhere. People were desperately trying to get inflation up. They could not do it.

Then you fast forward to 2020s, you know, you get you raised the federal funds rate up to 5% multi-deade highs. You didn't even get a recession, right? The inflation today is still like 3%. So the obvious observation that I make is that the link between interest rates and inflation is not very strong. So just even based on a economic argument saying that oh no Walsh is going to keep interest too low we'll have a resurgence in inflation that that's not founded in the experience of the past 20 years.

I guess the the devil's advocate to to that framework would be a critic would say that the neutral rate is much higher than it was 10 years ago. That you know a 5% in 2015 is very different from a 5% today because the neutral rate is x amount higher. How do you think about that?

Well, first of all, the neutral rate is something that's obviously made up. Uh but let's go let's go with that idea. Yeah. Well, back then they were thinking, oh, the neutral rate is actually really low. so low. In fact, let's have negative interest rates and they did that for many years in in some countries and it did didn't get you anywhere.

So, I think the fact is that inflation is dependent on many things. You know, fiscal spending, technology, demographics, sentiment and so forth. And when you sum that all up, the portion of it due to interest rate policy at least today is just not very large.

There are some theories as to why that's the case. a really good one that was proposed by Rick Reer and also you could see this in some academic writing as well is that we're just more of a servicesoriented economy, right? Let's say Felix you say block works for example a lot of media probably doesn't need to borrow a lot of money. If you're a newsletter writer you definitely don't need to borrow a lot of money and so whether or not interest rates are high or low just doesn't impact your business that much.

Now, rewind back maybe to the 80s, the 70s or 50s when you have a more industrial economy where a lot of uh to to build a factory or to do anything like that, you need to borrow a lot more money. You you probably have more of a your interest expense is something that you care more about. But in your services, like which is what the western economies largely are today, be it a barber shop, being a lawyer, practicing medicine, and so forth, it's just not that capital intensive. And so interest rates are not as impactful. Super impactful for the financial markets to be clear, but not so much it seems to the real economy.

Yeah, I think this is just my personal opinion, but that's what makes me kind of disappointed in in the choice of the Fed chair here is somebody like Reer, I felt like he had a framework that was really on point with how the economy is working in this modern day and age. He wrote about this I think last week where his his his notion of just how the economy is not nearly as sensitive anymore to changes in the Fed funds rate seemed really accurate to me and I was I was pretty compelled by just having somebody that really understood that versus now we're we have somebody that uh thinks that that that QE is is hyperinflationary and maybe he's revised his perspective and I'm just curious like does that I I agree with you agree with it like yeah so I for for me to be a good central banker or even a financial market participant is someone that has good judgment and that involves being able to update your mental model when things change right so in the markets in the economy macroeconomy things are always changing relationships between variables are always changing and so JP pal actually explicitly said this uh at his last meeting and I like that so and that's why you so for example um like interest rates sensitive mentioned in the past with that type of economy with that type of banking system maybe interest rate policy was really influential but it's obviously not today and people are able to update their models.

So in a sense because things are always changing you have to be humble and nimble as Cherpalo would say and maybe it's also why you sometimes see that people with a lot of experience in markets eventually that becomes a liability but what Rick Reer is saying is obviously unconventional and so that tells me that he can update his models and not just that something else that I thought was super interesting is that he noted that higher interest rates can even be stimulatory in some ways.