Warsh Calls for Fed-Treasury Plan to Smooth Balance-Sheet Unwind

  • In a critique at Hoover, former Fed governor urges wide reform
  • Says Fed suffers from group-think, complacency, defensiveness

Kevin Warsh Says Fed Needs Fundamental Reform

Former Federal Reserve Governor Kevin Warsh said the central bank and the U.S. Treasury Department should coordinate more closely as the Fed prepares to reduce its balance sheet.

Fed officials are planning to take their first steps toward shrinking their $4.5 trillion of bond holdings this year by trimming reinvestment on maturing Treasury and mortgage-backed securities. The timing and amounts are still under deliberation, but in minutes of the March meeting most officials said they should begin “later this year.”

The Fed’s portfolio has $136 billion of Treasuries coming due this year. The Fed will reinvest some of the proceeds, but whatever amount it doesn’t has to be financed by the Treasury in public markets.

“You would coordinate the shrinking of the balance sheet with the Treasury,” Warsh said in an interview with Bloomberg Television’s Michael McKee at a Hoover Institution conference at Stanford University in California.

The Fed deliberately skewed its Treasury purchases during the crisis toward longer-term securities to help push down long-run financing costs for corporations and households as a way to add stimulus to the economy. Just how the Treasury decides to finance its additional debt as the Fed allows the balance sheet to roll off could impact interest rates on certain maturities.

Treasury’s Plans

The Treasury said earlier this week the Fed’s balance sheet shrinkage “could affect Treasury’s net marketable borrowing from the public over the coming year.” The department would likely need to increase borrowing from the public, probably starting with more bills before moving to longer-term debt.

“The sooner they come out with principles, the easier markets can adjust and, importantly, the easier the Treasury can know what their issuance calendar should be,” Warsh said. “We are all part of one government.”

Last year, the Fed bought about $216 billion of Treasuries through noncompetitive bids to keep its holdings steady.

While Fed Chair Janet Yellen and U.S. Treasury Secretary Steven Mnuchin do meet regularly, the Fed typically avoids direct coordination with fiscal authorities on its policies to protect its independence.

Warsh also accused U.S. central bankers of complacency and called for major reforms in the way the monetary authority operates.

“Leading Fed officials are confidently predicting a benign external environment,” he said in remarks at Hoover, a think tank with at least three economists who’ve worked for Republican administrations. “The last time I recall such uniformity of opinion -- among central bankers, academics and market pros -- was just over 10 years ago” before the financial crisis.

Widespread Reform

Reprising a theme he has sounded before, Warsh urged the Fed to adopt a medium-term strategy for carrying out monetary policy that places less emphasis on the ups and downs of the financial markets and on the latest release of backward-looking economic data.

He said the Fed should be more open to suggestions for change from outside the organization and not reflexively reject them in the name of protecting its independence.

“The Fed’s existing model of governance is ripe for reform,” said Warsh, a visiting fellow at Hoover. “The Fed should straighten itself from its defensive crouch.”

Warsh, who has been mentioned as a possible candidate to succeed Yellen as Fed chair next year, sidestepped a question during the Bloomberg interview about whether President Donald Trump’s administration was sympathetic to his views. Instead, Warsh argued that the Fed has the power to make its reforms on its own.

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