Warsh confronts inflation headwinds for rate-cut plan

Kevin Warsh is set to become Fed chair and proposes cutting the policy rate over time while shrinking the Fed’s balance sheet. He links planned rate cuts to faster productivity growth and plans aggressive reductions in holdings of Treasuries and mortgage-backed securities.

Warsh argues that higher productivity-through technology and efficiency gains-can raise output per worker, lower unit costs and allow firms to pay higher wages without triggering faster inflation. He expects those effects to create room for lower short-term rates over the medium term.

Since his nomination, financial markets have reduced expectations for near-term rate cuts. Treasury yields have risen and traders have reversed bets on rapid easing. Geopolitical tensions in the Middle East and a temporary closure of the Strait of Hormuz have pushed energy prices higher. U.S. consumer price inflation rose to 3.8% year-over-year in April, and some forecasts place May at about 4.2% year-over-year.

Federal Open Market Committee participants have responded to firmer inflation by keeping all policy options open. Several officials have adopted a more cautious tone and have warned that policy may need to be tighter if price pressures persist. Officials and market participants have limited visibility on when energy-driven price shocks will fade and when productivity gains will affect inflation.

Warsh’s policy combines lower short-term rates with balance-sheet reduction. Lower rates would reduce borrowing costs and support activity. Reducing the Fed’s asset holdings would remove liquidity and could tighten longer-term financial conditions. Backers say the combination could reassure officials concerned about inflation; critics raise operational and political questions about rapid balance-sheet shrinkage and question whether it would offset the easing effect of lower rates.

The Fed makes decisions by committee and Warsh will need majority support for his approach. Market observers will watch the timing of any rate moves and the pace and mechanics of balance-sheet changes.