Warsh Has a Fairy Tale View of Fed Rate Policy
Significantly shrinking the central bank’s balance sheet is the wrong way to lower short-term interest rates.
A leading candidate to head the Federal Reserve has some unorthodox views on rates.
Photographer: Paul Morris/Bloomberg
If the Federal Reserve were to significantly shrink its balance sheet, would that enable policymakers to cut interest rates significantly? The argument made by former Fed Governor Kevin Warsh, who is a candidate to replace Jerome Powell as chair of the Fed, and some others is that such a move would reduce the amount of liquidity in the financial system. As a result, financial conditions would tighten and the Fed would respond by lowering short-term rates. In Warsh’s telling, households and small businesses would benefit from lower short-term rates and financial markets would become less exuberant and overheated.
Although sounding plausible enough — a smaller balance sheet would lead to lower short-term rates - it’s mostly a fairy tale.