Hawks turn doves? Walsh at the helm of the Federal Reserve: Can balance sheet reduction and interest rate reduction go hand in hand?

As the youngest Fed governor in history, who served from 2006 to 2011, Warsh has long portrayed himself as an "austerity hawk", and has continuously criticized the Fed for excessive post-crisis expansion and policy intervention for many years;

But in recent years, its stance has changed significantly, and it has begun to publicly support interest rate cuts. This contradictory policy orientation has made the market full of speculation about the direction of the Federal Reserve under his helm - especially whether he will launch a combination of "balance sheet reduction and interest rate reduction" policy, which will loosen the restrictions on US government debt issuance and open up the space for fiscal policy. It has become the core concern of global financial marekts.

The road to office remains uncertain: nomination hearings and core points of contention

Warsh's qualifications as chairperson of the Federal Reserve still need to pass the "big test" of the Senate Banking Committee's nomination hearing, which is also the first time his policy proposals have been publicly questioned in full.The core controversy focuses on three major dimensions.

First, the issue of the independence of the Federal ReserveTrump has clearly asked the new chairperson to promote interest rate cuts, and how to balance political demands with the central bank's independent decision criteria will be a key question point at the hearing.

Second, the contradiction between the path of inflation and interest ratesThe current March CPI rose to a nearly two-year high of 3.3% year-on-year, compounded by geopolitical conflicts in the Middle East that have pushed up energy inflation, and the window for interest rate cuts has been called into question.

Third, conflicts of interest and investigation disputes.Some Republican lawmakers are withholding support for his nomination on the grounds that the Justice Department's investigation into the renovation of the Federal Reserve headquarters has not been completed, and concerns about conflicts of interest caused by Warsh's hundreds of millions of dollars in personal assets will still be the focus of inquiries, although he has promised to sell related assets to avoid risks after taking office.

However, thanks to Trump's strong support and the support of some Wall Street forces, the probability of its approval by the Senate is high, and there may be a delay in the process. If Powell fails to obtain approval before the end of his term in May, the latter will assume his duties temporarily.

Policy core logic: the unique path of "shrinking the balance sheet for easing"

If Walsh takes office smoothly, the core of his policy will revolve around "exchanging balance sheet for easing", which is different from the traditional idea of "interest rate cuts must expand the balance sheet". The implementation of the combination of "balance sheet reduction + YCC + interest rate reduction" may provide key logical support.

Warsh has long advocated a return to the Fed's status as a "small central bank", arguing that the current $6.70 trillion balance sheet is a "bloated product" of the crisis that distorts financial pricing excessively and squeezes private investment space.

He explicitly opposed multiple rounds of large-scale quantitative easing after 2008, criticized the Fed's balance sheet as a core tool for intervening in the market, and particularly questioned the rationality of expanding the balance sheet to nearly $9 trillion during the epidemic.

Even after the Fed stopped reinvesting assets at the end of last year and started to passively reduce its balance sheet, Mr. Warsh publicly criticised the lack of force, stressing that "deep balance sheet reduction is the prerequisite for long-term interest rate cuts" - in his view, the policy space freed up by balance sheet reduction can be converted into interest rate reduction dividends, which will precisely benefit residents and small and medium-sized enterprises, rather than mainly flow to large institutions as in the past.

This line of thinking just provides the feasibility of the "interest rate cut + YCC" combination.

Traditional YCC (yield curve control) requires the central bank to directly buy long-term government bonds and suppress long-term interest rates, which is often accompanied by expansion of the balance sheet, which is easy to exacerbate the risk of inflation and asset bubbles;

But Walsh's path is to "shrink the balance sheet in parallel with interest rate cuts, and replace total easing with structural easing": on the one hand, promote the orderly contraction of the balance sheet, gradually reduce the holdings of long-term government bonds and MBS increased during the epidemic, and withdraw excess liquidity;

On the other hand, in response to the demand for government bond issuance, implicit YCC is implemented through targeted operations - when the Ministry of Finance issues new long-term Treasury bonds, the Federal Reserve moderately slows down the pace of reducing its holdings of corresponding maturity assets, or adjusts market liquidity through repurchase tools to avoid long-term interest rates from rising sharply due to government bond issuance, or through reserve reform, banks become the main body of purchasing Treasury bonds, which not only stabilizes the cost of Treasury bond issuance, but also does not significantly expand the size of the Federal Reserve's balance sheet. It also increases the Federal Reserve's regulatory tools and maintains the independence of the central bank

The Constraint of Interest Rate Cuts: The Double Test of Inflation and Internal Decision-Making

Although Walsh's proposal to cut interest rates has Trump's political endorsement and is in line with his logic of "shrinking the balance sheet for easing", its implementation still faces the dual constraints of inflation and the Fed's internal decision-making.

From the perspective of the inflation environment, the current interest rate cut window has not yet been opened. In March, the US CPI rose to 3.3% year-on-year, a new high in the past two years. The month-on-month growth rate is the fastest since 2022. Superimposed on the Middle East, geopolitical conflicts continue to push up energy prices, and the risk of energy-input inflation is still fermenting.

The Treasury secretary has made it clear that "this is not the time to cut interest rates", and advocates that the Fed prioritize watching inflation shocks from geopolitical conflicts, which is in line with the consensus of most Fed officials - including former dovish governor Christopher Waller, most members advocate "stay put", and Chicago Fed President Austan Goolsbee even bluntly stated that "there may be no conditions for interest rate cuts in 2026".

From the perspective of the decision-making mechanism, the Federal Reserve implements a collective decision-making system, and the majority support of the 12 FOMC members is a necessary condition for interest rate cuts.

As chairperson, although Warsh has the power to set the agenda of the meeting, he does not have the power to unilaterally adjust interest rates. If he wants to push for interest rate cuts, he must convince enough members to agree with his core judgment that "AI-driven productivity increases will suppress inflation" - that is, technological progress can achieve high growth and low inflation, creating space for interest rate cuts.

Therefore, even if Walsh takes office, the rate cut is likely to be a "gradual and lagged" operation: first stabilize the internal consensus with a "wait-and-see assessment", and wait for the geopolitical conflict to ease and inflation to continue to fall. After the signal, we will jointly push for a small rate cut with members with similar positions, and implement 2-3 adjustments of 25 basis points each time throughout the year.

Combination and fiscal expansion: the linkage space between government bond issuance and fiscal policy

If the combination of "interest rate cuts + implicit YCC + structural easing" can be implemented, it will directly open up space for the US government to issue bonds and expand fiscal policy, forming a linkage effect of "monetary loosening - fiscal force".

On the one hand, the combination of interest rate cuts and YCC will significantly reduce the cost of government bond issuance.

The current US federal government debt has exceeded 34 trillion US dollars, and the pressure on interest expenditure continues to increase. The stability of long-end interest rates is crucial to the sustainable issuance of government bonds.

The implicit YCC envisioned by Wash can stabilize the yields of 10-year and 30-year government bonds at relatively low levels by adjusting the pace of balance sheet reduction and liquidity tools, avoiding a sharp rise in interest rates due to large-scale bond issuance, which not only reduces the financing cost of new government bonds, but also relieves the interest burden of existing debt, allowing the government to have greater scope for the scale and frequency of bond issuance.

On the other hand, structural easing will empower fiscal policy. The "balance sheet reduction to release resources and turn to interest rate reduction" advocated by Warsh is not the traditional total easing, but more precise liquidity guidance - reducing the financing costs of residents and enterprises through interest rate cuts, boosting economic vitality and tax base;

At the same time, the assets reduced by the Federal Reserve in the process of shrinking the balance sheet are mainly large institutional-related assets increased during the crisis, reducing the crowding out effect on the private sector.AlfordMake room for fiscal policy efforts.

For example, the government can increase spending on infrastructure and people's livelihood through new government bond financing, while the loose monetary environment and stable interest rate level will reduce the "crowding out effect" of fiscal policy and improve the efficiency of policy transmission.

Landing Barriers: Uncertainty Under Triple Constraints

Although the "interest rate cut + YCC + easing" combination has theoretical logic and practical needs, the implementation still faces triple core obstacles, which may weaken its supporting effect on fiscal expansion.

First, the internal consensus of the Federal Reserve is difficult to reach, and there are many members of the FOMC who are opposed to the YCC, believing that it will over-intervene in market pricing and erode the independence of the central bank.

And some members have doubts about the feasibility of "shrinking the balance sheet and cutting interest rates simultaneously", fearing that shrinking the balance sheet too quickly will trigger a sudden stop in liquidity and a credit crunch, which will restrict economic and fiscal strength.

Second, the path of fiscal coordination has been blocked. The "Fed-Treasury coordination" model envisioned by Warsh is similar to the "fiscal agreement" during the New Deal era, but this idea has been publicly rejected by Treasury Secretary Bescent. Without the cooperation of the Treasury, the Fed's implicit YCC operation will be difficult to accurately match the rhythm of government bond issuance, and the policy effect will be greatly reduced.

Third, the external environment and inflation are subject to repeated risks. If the escalation of geopolitical conflicts in the Middle East leads to a sharp increase in energy prices, or the tight labor market pushes up wage inflation, the Federal Reserve may be forced to suspend interest rate cuts or even resume interest rate hikes. The combination logic of "interest rate cuts + YCC + easing" will directly collapse, and the cost of government debt issuance and fiscal expansion will be limited.

conclusion

If Walsh takes the helm of the Federal Reserve smoothly, it is not a fantasy to cut interest rates and ease while maintaining the independence of the Federal Reserve, but a natural extension of its policy logic of "shrinking the balance sheet for easing". One of the core goals is to loosen the bond issuance of the government and strengthen the ability of fiscal policy.

However, the implementation of this combination needs to break through the three major constraints of internal decision-making, financial coordination, and inflation fluctuations, and ultimately it is more likely to present a compromise pattern of "moderate interest rate cuts + balance sheet shrinkage + structural easing".

For the market, it is important to focus on the policy pronouncements at its nomination hearings, changes in the composition of the FOMC, and the evolution of inflation and geopolitical conflicts - factors that together will determine the strength of the Fed's policy shift, which in turn will affect the actual scope for US fiscal expansion and the direction of global financial marekts.

With balance sheet reduction as the core, combined with regulatory reform and monetary policy tools, we can not only solve the problem of inefficiency in the financial system, but also create space for fiscal and economic growth, while adhering to the bottom line of central bank independence.