Kevin Warsh is expected to become the next chairman of the Federal Reserve after getting the nod from the Senate Banking Committee. Assuming the full Senate confirms his nomination, he will succeed Jerome Powell (who has held the position since 2018) by May 15.
Powell, however, has said he will not leave the Federal Open Market Committee, which oversees the Federal Reserve’s monetary policy decisions. He plans to remain governor and could represent a stark contrast to the incoming president.
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Kevin Warsh disagrees with a key policy that Powell has supported and that has been used to influence interest rates without directly changing the target federal funds rate. And reversing the course of this policy could have a major impact on financial markets.
Image source: Federal Reserve.
The two tools of the Federal Reserve
Warsh believes that the Federal Reserve has two main tools to fulfill its dual mandate of full employment and stable prices. The first tool gets a lot of headlines: interest rates. The Federal Reserve is responsible for setting the target overnight borrowing costs for banks, the federal funds rate.
The second tool, maintaining a balance of bonds and reserves, is where Warsh maintains a very different stance than Powell and his recent predecessors. “I think the Fed’s balance sheet has played a particularly unhelpful role in helping the Fed achieve its dual mandate,” Warsh said at his confirmation hearing. While Powell’s Fed has used the balance sheet to buy long-term government bonds and mortgage-backed securities to adjust long-term interest rates, Warsh believes that is a mistake.
Warsh would prefer to reduce assets on the Federal Reserve’s balance sheet, which would have a noticeable impact on the markets. The Federal Reserve currently has more than $6 trillion in securities on its balance sheet. A massive seller in the market would put pressure on bond prices, thus increasing the effective interest rate. The FOMC could offset that increase by lowering the target federal funds rate, something President Trump has been pressing Powell to do since the start of his second term.
However, reducing the balance sheet without disrupting markets is a difficult task. When the Federal Reserve sold assets in 2019, short-term interest rates soared along with long-term interest rates. In the last balance sheet reduction campaign, launched in 2022, the same thing happened, causing a change of course starting in December.
Warsh has acknowledged that it will take a long time to undo the balance. Even if done with the utmost caution, the impact on investors will be notable, and not just on bond investors.
The stock market could see some major changes
Warren Buffett once made the analogy that interest rates are like gravity for asset prices. Higher interest rates mean lower asset prices. This is because all other assets are first compared to the risk-free rate that investors could receive when purchasing Treasury bonds.
If long-term interest rates rise, investors will apply a greater discount to companies’ future earnings and cash flows. This could hit growth stocks especially hard, as they are expected to produce significantly more earnings and cash flow in the future.
If those gains are discounted at a higher rate, they are worth less today. As a result, the S&P 500 and Nasdaq Composite could see a drop in value.
However, beyond valuations, borrowing costs will rise for many consumers and for some companies issuing longer-term debt. That could slow consumer spending and reduce profit growth for many companies.
If higher long-term rates allow the Federal Reserve to reduce the target federal funds rate, this could mitigate some of the pressure. What’s important for investors is that lower short-term borrowing rates and a steepening yield curve (where the gap between short-term and long-term rates widens) would favor slower-growing value stocks.
Investors should position their portfolio to prepare for a new Federal Reserve under Warsh’s leadership. While he will face some opposition, including the likelihood of clashing with Powell, he will have enormous influence over the future of central bank policies and could have a big impact on his portfolio.
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Fed Chair Candidate Kevin Warsh Disagrees with Jerome Powell on This Key Stock Market-Supporting Fed Policy (Hint: Not Rate Cuts) was originally published by The Motley Fool
