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There is a certain “truthiness”, as the comedian Stephen Colbert might put it, to the idea that we are about to have a get-real conversation about monetary policy in the US. Despite constantly calling for lower interest rates, President Donald Trump has nominated as the next Federal Reserve chair Kevin Warsh, who announced a little over two months ago that “money on Wall Street is too easy, and credit on Main Street is too tight”. Amen.
He says he wants to trim the Fed’s massive balance sheet, which could raise longer-term interest rates. Of course, Warsh is also a savvy political operator who seems ready to do Trump’s bidding. He has said he believes America might be on the cusp of an AI-related productivity boom that will dramatically boost workers’ output, allowing the Fed to cut rates without stoking higher prices. Nobody knows whether that is true yet.
But Warsh is “truthily” right about one thing. America has become dangerously reliant on the “Fed put”. By counting on the Fed to intervene whenever things get rough, Washington policymakers have punted on tough fiscal policy decisions and relied on easy money and low rates to bolster markets and GDP growth for decades now.
Can he fix that problem? My early guess is no.
To rely less on monetary policy, no matter who is in charge at the Fed, you would have to have smart fiscal policy that really addresses the challenges on Main Street. Simply making credit to small business more accessible won’t retrain a workforce, fix the housing market or reduce healthcare costs. To do that would require serious “guns and butter” conversations about budgetary trade-offs, as well as a Congress and a White House willing and able to have them.
We haven’t had either since the 1960s.
The term “guns and butter” brings to mind former president Lyndon Johnson, who famously tried to wage the Vietnam war and launch his Great Society social programmes simultaneously without raising taxes. This led to both a widening fiscal deficit and inflation.
That problem was ultimately curbed by Paul Volcker. It was the last time a Fed chair took truly decisive (and painful) action that went against the political tides. But it was also a definitive turning point that showed that the Fed could, in fact, ensure macroeconomic stability.
Since then, every president and every Congress has been turning to the Fed to do just that. The result has been a half-century trend of declining interest rates, several bouts of quantitative easing with questionable impact on real economic growth and a rising number of financial boom-and-bust cycles.
The latter are always painful. But for Congress and for American presidents, they are apparently less painful than telling voters the truth: that the US is spending well beyond its means, and that there will eventually be a higher risk premium to pay as a result. If we don’t want to see inflation higher and the dollar devalued, we need to make some budgetary sacrifices to get the debt situation under control.
Neither Trump nor this captive Congress will be the ones to do that. Instead, we seem to be set for a repeat of the Reagan-era policies of tax cuts, deregulation and defence build-up (witness Trump’s $175bn “Golden Dome” programme) at a time when federal debt to GDP ratios are more than three times what they were back then. Treasury secretary Scott Bessent may call himself a deficit hawk, but last year’s tax cuts just added another 1 per cent of GDP to the deficit, and the Trump tariff rebate proposals could easily double that figure.
Maybe if you really believe that a major productivity boom is just over the horizon, you could imagine running an economy this hot without creating inflationary pressures. I hope that will be the case. But there is an equal chance that the combination of tariffs, re-industrialisation, immigration cuts (which constrain the labour force) and some new supply chain disruption (which could easily happen for reasons ranging from geopolitics to natural disasters) will push up costs before Trump’s term is over.
What will Warsh do then?
He took a hard — and I believe correct — stance around easy money when Democrats were in charge during the financial crisis and Covid-19. Progressives wanted several rounds of QE and lower rates to bolster incomes at the bottom of the socio-economic spectrum, and plenty of market participants wanted them to juice share prices. But there was never much chance that all that easy money could offset the structural shifts in the economy that worked against low-skilled domestic labour. QE, particularly the latter rounds, was a palliative that couldn’t even offset the rising cost of things such as housing, education and healthcare.
If Warsh now takes a soft money approach under Trump without very good and consistent data to show that AI is really shifting the inflation story, then we will know he is simply “truthy”, rather than principled. We will also know that we have reached a new stage in the “Fed put”.
Here, Trump’s demands for lower rates and his treatment of current Fed chair Jay Powell have set a dangerous new precedent. The central bank has been used by many politicians to end-run debt and deficit issues. The question now is whether it will be used by Trump to end-run democracy.
