At Kevin Warsh’s swearing-in as Fed chair, one line from Trump’s remarks stood out: “economic growth doesn’t mean inflation. It can be just the opposite actually… You don’t have to stop the world because you’re doing well.” He reiterated the point in a recent NBC interview: “Growth does not cause inflation… When a country is doing well, they shouldn’t be penalized by immediately raising interest rates; they should actually be incentivized.”
To us, this sounds like Warsh has a new “third mandate” to manage. On top of the Fed’s official objectives — “maximum employment” and “2% inflation” — now sits a third: that economic growth needn’t be answered with rate hikes, and perhaps even that a strong economy can still warrant rate cuts.
The Iran deal helps, but mostly in medium term
Overall PCE inflation reached 3.8% in April—the highest yearly growth rate for the Fed-preferred inflation gauge since May 2023. On top of that, US inflation has failed to fall back to the central bank’s target of 2% for more than five years. How is it possible to cut rates?
One potential argument is that the US and Iran reached a “permanent” peace deal on Sunday (and the White House claimed that it will be signed on Friday). The deal will partially, if not fully, restore traffic through the Strait of Hormuz and increase the supply of crude oil and other oil products, easing the cost-of-living pressure from high oil prices and other related supply chain issues.
But of course, a peace deal—even if fully and successfully implemented, which is not guaranteed—will not solve all the inflation pressures overnight. For example, the countries need to rebuild their oil reserves, Europe needs to replenish its gas storage, and oil tankers need to normalize their transit schedules. Energy prices can remain higher than pre-war levels for longer.
Nonetheless, as long as the war is in the rear-view mirror and inflation expectations remain anchored, Warsh can claim that the elevated fuel cost is short-lived and hence the Fed should rest assured that it can “look-through” the episode. (We previously coined this as the “War?Sh!” strategy as there is no need to talk about the war anymore.) The Fed, he may further argue, should focus on the domestic economy which is benefiting from the AI-led positive supply shock.
Will they introduce a ‘hawkish bias’?
Well, that is what Warsh, and maybe also Governor Michelle Bowman, may advocate. It doesn’t mean all other Fed officials will have to agree with the new Fed chair.
At the last meeting, three Reserve Bank Presidents—Lorie Logan of the Dallas Fed, Neel Kashkari of the Minneapolis Fed, and Beth Hammack of the Cleveland Fed—dissented from the central bank’s decision to continue to include an “easing bias” in its policy statement. In the intermeeting period, all of them reiterated their hawkish view.
Logan, in her last speech before the blackout period, said:
I am increasingly concerned that higher interest rates could be necessary later this year to fully restore price stability and appropriately balance both sides of the Fed’s dual mandate.
Hammack, as we have previously covered, has similarly argued that the May “jobs report reaffirms that the labor market appears to be roughly in balance” and that she “believe[s] persistently high inflation is the bigger concern,” adding that if recent inflationary trends continue, “it may soon be appropriate to act.”
Which is why we should watch closely whether the three regional Fed presidents will argue not just for a removal of the easing bias—as this is the likely base case for the changes in the statement—but go a step further to ask for the introduction of a “hiking bias” in the statement to say that the next change in interest rate will likely be an increase.
Powell can take the role of scapegoat to “protect” Fed independence.
Most importantly, we think the consensus is currently underweighting the potential for the Warsh Fed to hike.
What prompts analysts to second-guess the rate hike probability is the low interest rate most of us have assumed Warsh promised Trump. No matter how hawkish Warsh’s previous stance was, the low-rate promise is what got him the job and he is likely to fulfill the pledge.
However, the fact that Jerome Powell remains a Fed governor may change the calculus a bit. As we have observed before, Powell can potentially give Warsh a longer than usual honeymoon (or, hawkish-moon) period from Trump as the former Fed chair could become a scapegoat and help Warsh absorb some of the blame for the “elevated” interest rate.
Trump seemingly understands the concept that Powell’s decision to stay has delayed Trump-appointees from holding a majority in the Fed board of governors. (Though this counts Governor Chris Waller as one of the Fed officials who would align with the White House’s monetary policy thinking, which is an oversimplification of Fed politics.) Trump is open to giving Warsh some space for now, as he also openly stated in the NBC interview:
“Kevin is fantastic, and I want him to do whatever he wants,”
“I don’t want to have a big influence on him.
Our assumption is that when the time comes that Trump turns impatient about the interest rate level or a majority of the FOMC decides to raise rates, Warsh can opt to convince Trump that Powell remains the culprit and leader of this movement and that Trump should pressure Powell instead of him.
This hypothesis can be tested by observing who Trump will blame when he next complains about monetary policy on Truth Social: “too late” Powell and the Reserve Bank presidents or “central casting” and “handsome” Warsh. As long as Powell stays, we think he will remain the major target and Warsh will refrain from providing any help.
Moreover, we assume that Powell will willingly take all of this blame to provide cover for the new Fed chair. The rationale is simple: by shielding the Fed chair from political pressure, Powell gives Warsh the cover he needs to do what’s best for the economy. This is, to a certain extent, the realization of Fed independence. Although it comes via a twisted path, I think this is an offer Powell will not refuse.
By being a scapegoat for Warsh, Powell will be the GOAT (greatest of all time) for the Fed.
