The 12 Labours of Kevin Warsh

Kevin Warsh officially became the new Federal Reserve chair on May 22, but his real work begins at the Federal Open Market Committee (FOMC) meeting on June 16 and 17. From that point on, his words and actions will be judged by markets, politicians and the general public, and he’ll gradually find his place among his distinguished predecessors. Will he go down in history alongside Paul Volcker, hailed as one of the Fed’s best chairs, or Arthur Burns, viewed as one of its worst?

Like Hercules, who was forced to complete 12 labours to earn his place among the gods of antiquity, the new Fed chair also faces a series of challenges that will reveal whether he can effectively lead the world’s most powerful central bank.

I. Managing the Fed’s Messaging and Market Expectations

Since Ben Bernanke’s tenure as Fed chair, the institution has stressed clear communications and transparency. The Fed uses speeches, testimony, written reports (like the Beige Book and meeting minutes) and quarterly projections to steer market expectations and avoid shocks that could trigger volatility. But this has also made markets extremely sensitive to, and even dependent upon, the Fed’s signals. In particular, they read far too much into the Fed’s projected policy rate trajectory (commonly referred to as the dot plot). This forward guidance hints at the future direction of monetary policy but can also limit Fed officials’ scope of action and lead to a loss of credibility if they deviate from it too abruptly or too often. In fact, Warsh himself has often criticized the Fed’s use of forward guidance in the past. He’ll need to strike a balance between satisfying the markets’ desire for clarity regarding the direction of monetary policy and giving Fed policymakers more flexibility.

II. Protecting Fed Independence and Restoring Confidence

Donald Trump’s repeated criticisms of the Fed, and more specifically of Warsh’s predecessor Jerome Powell, have weakened the institution’s standing and created an additional constraint for its new chair. What will Warsh do if the President of the United States renews his attacks on the central bank? During his Senate confirmation hearing, Warsh said that elected leaders are entitled to state their views, and that Donald Trump wasn’t the first to do so. But it’s ultimately up to the Fed to decide on the course of action that best supports its mandate. That said, previous Fed chairs have yielded to attempts at interference that weren’t nearly as blatant as Trump’s attacks. For example, President Nixon’s influence over Arthur Burns in the early 1970s was one of the factors leading to that decade’s high inflation. Warsh will also have to contend with legal pressure from the Trump administration with respect to Governor Lisa D. Cook and the now-internal investigation into cost overruns for renovating the Fed’s headquarters. Finally, public confidence in the Fed and its chair has been damaged both by Trump’s repeated criticisms and especially by what many saw as its poor handling of monetary policy in the aftermath of the pandemic (graph 1). Restoring the institution’s credibility should be a major priority for Warsh.

III. Balancing Trump’s Demands with Market Pressures

The question of Fed independence may influence monetary policy decisions in the near term. It’s clear that Trump always wants policy rates to go down, reflecting both his present role as a politician and his past as a real estate developer. The current occupant of the Oval Office believes that lower rates are needed even when the economy is running hot, which runs counter to conventional economic thinking. But, based on economic and inflation forecasts, the market may expect higher policy rates and build those expectations into bond yields. The Fed will need to follow its own forecasts and analysis, and focus more on ensuring markets remain orderly than responding to the whims of the President of the United States. We should also keep in mind that as of January 2029, Warsh will have to deal with a new US president who will decide whether to renew his term.

IV. Managing the Current Situation, Including the Impact of Rising Energy Prices

In the very short term, Warsh and the other FOMC members will need to decide on the best monetary policy for the current economic environment. And that’s no simple matter. On the one hand, energy prices have sent US inflation above 4%. A few months ago, the slack labour market caused some concern, but it’s less of a problem now after three months of relatively strong hiring. If the economy remains resilient and the cost of living continues to rise, inflation expectations could once again become de-anchored from the Fed’s inflation target. That said, the US economy does have weak spots that are currently being concealed by tech sector growth and the artificial intelligence boom.

V. Bringing Long-Term Inflation Expectations Back to Pre-Pandemic Levels

Long-term inflation expectations were unsettled at the beginning of the post-pandemic period. After two decades of stability—and even fears of persistently below-target inflation in the 2010s—those expectations shifted in just a few years. Although expectations have been contained by the sharp decline in inflation after the 2022 peak, they remain higher than they were before COVID‑19 (graph 2). This continues to undermine Fed credibility, but bringing expectations down even further entails some real risks. Under Warsh, the Fed will simultaneously want to avoid policy rates that are too high for current economic conditions and an overly accommodative monetary policy that would entrench high inflation expectations.

VI. Dealing with a Possible Recession

The United States will eventually have to deal with another recession. Since the Fed was founded in 1913, only two of its chairs have not experienced a recession during their term: William Miller, who was in office for only 17 months, and Janet Yellen, who served from 2014 to 2018. In fact, Fed chairs are often judged based on their response to economic downturns. At such times, the FOMC needs to respond to the situation appropriately by recognizing the first signs of recession and reacting in accordance with its dual mandate of price stability and full employment. How much should monetary policy be eased given the depth of the economic slump? Will unconventional measures be needed? To what extent will the Fed and the government need to coordinate their actions to avoid a severe recession? Although the US economy has remained resilient since the pandemic, these questions will inevitably arise again.

VII. Watching Out for a Potential AI Bubble

The 2001 and 2008–2009 recessions were partly triggered by the collapse of financial bubbles. Is another such risk on the horizon? It’s a definite possibility given the AI boom, and Warsh and his colleagues at the Fed will need to pay attention to it. For the time being, markets are focusing more on the benefits of AI, such as increased investment, stronger asset values, potential improvements in productivity (which Warsh has already mentioned) and higher earnings. But that line of thinking sounds a lot like the claims made about the internet in the 1990s and the financial innovations that made it possible for more people to buy homes in the 2000s. In light of this, if it seems like a speculative bubble and asset overvaluation are starting to pose too much of a risk, the Fed will need to take away the punch bowl, as William Martin so famously put it.

VIII. Reducing the Fed’s Balance Sheet

The Fed still holds a significant amount of assets following the quantitative easing measures implemented during the pandemic. It has made some progress in trimming its holdings, but its balance sheet remains historically bloated. Warsh has long been a critic of the policies that expanded the balance sheet and led to the market’s overreliance on the Fed. He may want to introduce a new balance sheet reduction policy that is independent of monetary policy. But the market’s ability to absorb such measures will have to be taken into account. If poorly implemented, such a policy could drain too much liquidity from the system, thereby increasing financial stress.

IX. Ensuring Financial Stability in the Event of a Debt Crisis

In addition to setting monetary policy, the Fed is also tasked with promoting the stability of the financial system. That system obviously depends on the smooth flow of credit within the economy. In fact, concerns about the banking sector and the availability of credit exacerbated the 2008–2009 recession. As a result, the Fed and the government had to intervene directly to support the markets. The Fed must therefore monitor any risks that could undermine credit quality in the United States, starting with federal public debt. Although government debt continues to rise, investors still view it relatively favourably. But that confidence could eventually fade, and the Fed may need to take action to stabilize markets. A US public debt crisis could be triggered by policy decisions (increased spending, more tax cuts), partisan gridlock (yet another tussle over the debt ceiling is expected in spring 2027), fresh credit downgrades and so on. How should Warsh and his colleagues react under those circumstances? In addition, private debt is raising some questions that could present another challenge for the Fed. For now, the issue remains contained, but the risk of contagion from this relatively opaque market is increasing. Since this type of credit falls more outside the Fed’s direct mandate, the central bank’s ability to intervene is limited. But private debt could eventually have a significant impact on financial stability.

X. Refocusing the Mandate

In the past, Warsh has sharply criticized the Fed for overstepping its official mandate. In his view, by taking on issues that aren’t directly tied to inflation or employment, the Fed has played into politicians’ hands and consequently lost some of its credibility. Under Warsh, the Fed is less likely to be concerned about climate change, income inequality and social mobility.

XI. Reforming the Fed

Many of the administrative and policy reforms introduced by the Trump administration since taking office bear the imprint of Project 2025, which sparked intense discussion during the 2024 election campaign. That document lays out the blueprint for redefining the role of government, including the Fed. It calls for a less interventionist central bank that’s more tightly focused on fighting inflation, even if that means eliminating the maximum employment side of the Fed’s dual mandate. It also talks up the merits of a strictly rules-based monetary policy and even considers the possibility of returning to the gold standard, which would remove the Fed’s authority to make discretionary decisions about monetary policy. It remains to be seen whether Kevin Warsh can and will move ahead with deep reform of the Fed. But he recently hired Paul Winfree, the author of Project 2025’s chapter on the Fed, as an advisor.

XII. Addressing the Rise of Digital Currencies

Digital currencies pose several challenges for central banks, especially the Fed. Along with the Treasury Department, the Fed is the guarantor of the US dollar, which is the world’s principal medium of exchange. However, as digital currencies gain ground, they are beginning to challenge the greenback’s dominance and fostering parallel systems of exchange. This could reduce the effectiveness of monetary policy transmission, limiting the tools that the Fed can use to stabilize the economy and the financial system. It also disrupts the money supply in the economy by making alternative financing—without Fed regulation or oversight—more feasible. Cryptocurrencies are also highly speculative assets that are often volatile and could destabilize financial markets. The Fed therefore has to consider how far it can tolerate the rise of these assets, or even the extent to which it should play a role in this market. It’s also worth noting that President Trump has signed an executive order prohibiting the Fed from developing a central bank digital currency for the United States.

Of course, Warsh probably won’t have to face all of these challenges. But what he does with the Fed when some of them inevitably arise will tell us whether Trump made the right choice when picking him to lead the US central bank.