Kevin Warsh and the Return of Market-Priced Risk

Executive Summary

The debate surrounding Chairman Kevin Warsh has focused heavily on politics. President Trump has assertively expressed his preference for lower interest rates, inflation remains above the Federal Reserve's 2% target, and Warsh's approach to monetary policy raised questions about the Fed's independence and credibility.

Those questions matter. But they may be obscuring a more consequential change.

Warsh’s August 28th remarks point toward a more restrained approach to central bank communication and monetary policy. He described short-term interest rates as the Fed's predominant policy tool, argued that forward guidance should be limited in normal times, and said unconventional policies designed to stimulate economic activity may be appropriate in genuine crises but otherwise should be used sparingly.

He also emphasized a different relationship between the Federal Reserve and financial markets. Market signals should inform policymakers, but market participants should form their own expectations rather than rely primarily on the Fed for indications of future policy.

Taken together, those principles suggest a framework in which the Federal Reserve manages short-term money and provides the liquidity necessary to keep the financial system working normally, while the market determines the price and availability of long-term capital.

That would represent a meaningful departure from the post-Global Financial Crisis (“GCF”) regime. Over the past two decades, forward guidance, quantitative easing and tightening, and a much larger Federal Reserve balance sheet have given the central bank considerable influence over financial conditions well beyond the overnight market.

Markets adapted accordingly. Investors came to expect that sufficiently severe deterioration in financial conditions could eventually provoke a Federal Reserve response—the implied protection commonly described as the "Fed put" (the term is market shorthand, however, and does not represent an explicit Federal Reserve commitment or guarantee to support asset prices).

That expectation has economic value.

If investors believe the central bank will intervene when financial conditions deteriorate sufficiently, some portion of perceived downside risk may be viewed as buffered by the Fed. Investors may therefore accept lower compensation for bearing risk than they might otherwise demand.

Over time, this may have contributed to lower long-term risk premia and a lower market-clearing cost of risk capital. The consequences could potentially extend far beyond Treasury yields: cheaper leverage, tighter credit spreads, greater tolerance for indebtedness, and higher valuations for equities, real estate, and other long-duration assets.

In that sense, Federal Reserve policy may have inadvertently subsidized risk-taking.

Warsh’s recent remarks suggest he may be willing to challenge aspects of that arrangement.

If the Fed remains available to provide short-term liquidity when markets cease to function, but becomes less willing to intervene simply because asset prices fall, volatility rises, or long-term borrowing costs increase, private investors must once again bear more of the underlying risk.

That risk would need to be priced.

One possible consequence is a higher market-clearing price for long-term capital than investors became accustomed to during much of the post-GFC era. Even if inflation eventually returns to 2% and the Fed lowers overnight rates, 10- and 30-year yields could remain structurally higher if markets demand greater compensation for duration, inflation uncertainty, fiscal risk, and other long-term uncertainties without the same expectation of Federal Reserve intervention.

Higher long-term rates, in this framework, would not necessarily represent a failure of monetary policy. To some extent, they could reflect a greater role for the market in price discovery.

That distinction matters because the consequences could extend across the economy.

Mortgage and other long-term consumer borrowing rates could remain higher even as the Fed lowers short-term rates. Corporate borrowing costs could rise, increasing hurdle rates for investment and making highly leveraged business models less forgiving. Government borrowing costs could more directly reflect market assessments of inflation, deficits, and sovereign risk.

Risky assets could face the same repricing.

Equities, real estate, private credit, and other long-duration assets have operated in an environment in which both the risk-free rate and compensation for bearing risk remained unusually low for extended periods. If part of that environment reflected an implicit expectation of central-bank support, a reduced expectation of such support could increase required returns and place downward pressure on the valuations investors are willing to pay for some assets.

This need not imply an imminent collapse in asset prices. Nor does it establish that Federal Reserve policy alone created today's elevated valuations or high levels of leverage.

But it raises a more fundamental question: how much of the post-GFC valuation regime reflected genuinely lower economic risk, and how much reflected a lower price for risk because investors expected the Federal Reserve to respond to financial-market stress?

Warsh’s recent remarks suggest a greater willingness to let markets play a role in answering that question.

1. The Immediate Credibility Question

Financial markets have become increasingly focused on the relationship between Chairman Kevin Warsh and President Trump.

The concern is not simply political. Investors are asking whether the Federal Reserve remains willing to respond if inflation remains above target and further monetary policy action becomes appropriate.

Inflation has remained above the Federal Reserve's 2% target for roughly five years. President Trump has repeatedly advocated for lower interest rates, while Warsh has so far adopted a relatively cautious approach to additional tightening.

Meanwhile, long-term Treasury yields have, at times, risen even as the Federal Reserve has kept the policy rate broadly unchanged, widening the separation between the Fed-controlled short end and the market-driven long end of the curve.

Curve steepening does not by itself establish that term premia are rising. Expectations for future Fed policy, inflation, growth, and other cyclical variables all affect the slope.

But today's steepening is noteworthy because it is occurring against relatively weak growth expectations rather than expectations of a powerful economic recovery. The combination of softer growth expectations and rising long-term yields can be consistent with investors demanding greater compensation for holding duration for reasons other than stronger expected growth.

Markets do not require proof of political interference to adjust prices. They require only sufficient uncertainty that political influence cannot confidently be ruled out.

If investors become less confident that inflation will be addressed with sufficient determination, long-term rates can rise even if the federal funds rate does not.

But this may ultimately prove to be the smaller Warsh story.

2. A Different Philosophy of Central Banking

Warsh's individual policy preferences appear to fit within a coherent philosophy:

• Restore the federal funds rate as the primary instrument of monetary policy.
• Reduce reliance on forward guidance.
• Maintain a smaller Federal Reserve balance sheet.
• Return quantitative easing and tightening to exceptional rather than routine policy tools.
• Allow markets to determine the price of long-term capital.

Warsh does not appear to advocate a passive central bank. His remarks instead draw a distinction between the Federal Reserve's responsibility for monetary policy and the role financial markets play in processing information and establishing prices.

Warsh argued that the Fed should closely monitor market signals, including asset prices, Treasury markets, credit conditions, foreign exchange rates, and commodity prices. At the same time, market participants should evaluate economic information independently and form their own expectations about growth, employment, inflation, and risk.

The concern is that excessive dependence can run in both directions. If markets rely heavily on Federal Reserve guidance while policymakers simultaneously rely on market prices for information, the resulting feedback loop can distort the signals both groups are attempting to interpret.

The distinction can be expressed simply:

The Fed conducts monetary policy. The market prices the risk.

That also implies accepting outcomes that policymakers and investors may find uncomfortable.

A rise in long-term yields does not necessarily indicate market dysfunction. Neither does a widening of credit spreads, falling equity prices, or greater financial-market volatility.

If those prices reflect investors demanding greater compensation for risks they genuinely bear, allowing them to adjust can be part of market price discovery.

That appears consistent with Warsh’s stated preference for financial markets that process economic information independently rather than look primarily to the Federal Reserve for indications of their next move. We believe this is an important dividing line between Warsh’s philosophy and the post-GFC regime.

3. From the Post-2008 Fed to Warsh

Before the Global Financial Crisis, the federal funds rate overwhelmingly served as the Fed's principal policy instrument. Its balance sheet was comparatively small, and Fed’s direct influence on long-term financial conditions through balance sheet policy was much more limited.

Communication also played a more limited role. The Greenspan Fed was highly data-dependent and generally reluctant to provide explicit guidance about future rates, although that began to change following the dot-com collapse and September 11, and accelerated after the Global Financial Crisis.

Under Bernanke, Yellen, and Powell, communication evolved much further—from primarily explaining monetary policy toward becoming an instrument of monetary policy itself.

With overnight rates approaching zero, the Fed expanded its toolkit to include forward guidance, quantitative easing, large-scale purchases of Treasury and mortgage securities, and Operation Twist, which shifted its Treasury holdings toward longer maturities without materially expanding the balance sheet.

These tools allowed the Fed to influence financial conditions well beyond the overnight market.

The post-GFC regime also reflected an increased emphasis on financial stability. Markets gradually learned that sufficiently severe deterioration in financial conditions could itself generate a Federal Reserve response—the phenomenon popularly described as the "Fed put."

That expectation may itself have affected asset prices.

An investor who expects the central bank to respond to sufficiently severe market deterioration may perceive a different distribution of outcomes than one who expects markets to clear without intervention. The perceived downside may be viewed as at least partially buffered.

That can reduce the return investors require for accepting risk.

Repeated over many years, such a regime can encourage leverage, compress risk premia, and support higher valuations for assets whose prices are particularly sensitive to the cost of capital.

None of this establishes that the Fed created today's asset valuations or accumulation of debt. Technology, demographics, global savings, fiscal policy, financial innovation, and many other forces have also played important roles.

But Federal Reserve policy may have altered the price at which investors were willing to assume those risks.

Warsh’s remarks suggest he wants to draw the boundary differently.

The Fed would still address genuine market dysfunction. But volatility, wider spreads, higher long-term rates, or falling asset prices would not necessarily constitute dysfunction requiring intervention.

The market would be given greater responsibility to process information and price risk.

4. Two Routes to Higher Long-Term Rates

The political credibility debate and Warsh's structural philosophy are analytically different, but they could point toward the same direction in market pricing.

The first is cyclical.

If investors become less certain about the Federal Reserve's willingness to control inflation, they may demand greater compensation for holding long-term nominal bonds.

The second is structural.

For much of the post-GFC era, the Federal Reserve was willing to use its balance sheet and communication policy to influence longer-term financial conditions. Asset purchases removed duration from private portfolios, while the broader Fed reaction function may have reduced the perceived downside associated with financial-market stress.

If the Federal Reserve reduces reliance on those tools, private investors could be required to absorb more duration and bear more of the associated risk themselves.

That could increase the compensation investors demand for doing so.

The structural question is therefore straightforward:

What is the market-clearing price of long-term capital when investors no longer expect the Federal Reserve to routinely buffer long-term market risk?

The answer could be higher than investors became accustomed to during much of the post-GFC era.

Critically, that outcome does not require inflation to remain elevated.

Inflation could return to 2%. The federal funds rate could eventually fall. Economic growth could remain modest.

Yet 10- and 30-year rates could remain structurally higher if the private market is once again being asked to price duration, inflation uncertainty, fiscal risk, and other long-term uncertainties without the same expectation of Federal Reserve intervention.

The same principle applies beyond Treasuries.

Higher required returns could translate into more expensive corporate credit, greater discipline on leverage, and lower equilibrium valuations for some equities and other long-duration assets.

In other words, reducing expectations of a ‘Fed put’ does not necessarily create additional economic risk.

It may instead reveal the price of risk that was already there.

Conclusion: Letting the Market Price Risk

The political questions surrounding Chairman Warsh deserve attention.

Inflation remains above target, President Trump has repeatedly called for lower rates, and questions about Federal Reserve independence can affect the central bank's credibility.
But that may ultimately prove to be the smaller story.

Warsh appears to be questioning several defining features of the post-2008 Federal Reserve, particularly the extensive use of forward guidance and the reliance on unconventional monetary policy tools outside periods of genuine crisis.

His alternative is closer to the pre-crisis model.

The Federal Reserve manages short-term money and provides the liquidity necessary to keep markets functioning.

Markets price long-term capital and risk.

If the post-GFC Federal Reserve helped compress the market price of risk, reversing that regime is likely to produce some uncomfortable consequences: higher long-term interest rates, wider risk premia, more expensive leverage, and lower equilibrium valuations for assets that benefited most from cheap capital.

But those outcomes should not automatically be interpreted as policy failures.

A functioning capital market is supposed to discriminate between risks. Leverage carries a cost. Long-duration investments generally require compensation for uncertainty. And asset prices can fall without necessarily requiring a policy response.

Warsh's emerging approach appears willing to return more responsibility to the markets for interpreting economic information and pricing risk.

If so, the most important question may not be whether Warsh's Federal Reserve will support asset prices. It may be how markets price risk when they are expected to rely less heavily on signals from the Federal Reserve.

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