The markets are making a radical mistake if they believe that Warsh is ushering in a “regime change”. All we can do are Canada Dry tightenings.

The markets are making a radical mistake.Financial markets have welcomed with relief and optimism the first interventions by Kevin Warsh, the new Chair of the Federal Reserve.They see in them the sign of a possible return to a more “orthodox”, firmer monetary policy—one capable of disciplining inflation and curbing bubbles without hesitation.

This reading is seductive.It is also radically false.

It rests on two twin illusions:

first, that monetary policy is a matter of discretionary choice;

second, that the personality of the Fed Chair is the determining factor.

Neither is true.

Monetary policy is not the product of one man’s will. It is constrained, imposed, and dictated by the material state of the economy: the level of debt, the scale of deficits, the fragility of the financial system, the existence of speculative bubbles, and the absolute necessity of preserving financial stability.

Stocks create the need for flows

Powell provides a precedent that should serve as a warning. Let us recall what happened with Jerome Powell. At the beginning of his tenure, he believed—or at least suggested—that it was possible to normalize monetary policy after the excesses of the post-2008 era. He initiated a process of gradual tightening, balance-sheet reduction, and a return toward more “normal” rates. Markets initially believed him and even applauded this rhetoric of rigor.

Material, concrete, objective reality decided otherwise.

The pandemic, followed by the inflationary shock of 2021-2022, the U.S. government’s financing needs, market fragility, and the fear of a liquidity crisis forced Powell to pivot. He had to bend the knee.

The rate hikes necessary to bring inflation back to 2% were slowed and then partially reversed because the system could not withstand them without risking implosion.This was not a question of character or conviction. It was a question of structural constraints.

Warsh: same scenario, same constraints—and in my view even worse.

Kevin Warsh arrives with a more hawkish, more direct, more voluntarist discourse. He speaks of a regime change, criticizes the Fed’s excessive communication, and wants to refocus the institution on its price-stability mandate.

In a way, one could say he wants to break the dependency on stock markets, stop being held hostage, and return to sound management principles.Geithner, after the 2008 crisis, also thought he should move in that direction, but he quickly sobered up and realized—and wrote—that the connivance with finance had to be maintained, otherwise it would take revenge. Bernanke never dared attempt the Exit!

Markets, as I noted in my weekly analysis, are currently giving him credit. They are even anticipating a possible rate hike as early as September and applauding this firmer tone. They are mistaken again.Warsh can speak, he can harden his language, he can even attempt a few symbolic gestures. But he will very quickly run up against the same material realities that shattered Powell’s normalization ambitions:

• A U.S. public debt that continues to accumulate at an unsustainable pace.
• Structural budget deficits that require abundant and low-cost financing.
• High-risk zones in private credit, private equity, and the basis trade.
• Speculative bubbles (extreme valuations, record leverage, AI and tech euphoria) that cannot withstand any significant tightening of financial conditions without triggering a crisis.
• Financial stability, which ultimately always takes precedence over doctrinal purity.

As I regularly write, a genuine tightening of financial conditions is necessary to contain persistent inflation and change behaviors, but it is politically, socially, and financially perilous.All we can do are Canada Dry tightenings—they look and taste like the real thing, but they are not.

The system is already in a state of “criticality”: any excessively brutal tightening risks triggering cascades of defaults, a contraction of credit, and a liquidity crisis.

Public participation in the stock market is disproportionate for an asset class that is not supposed to carry so much risk.

The wine is drawn; it must be drunk.

The world is materialist, not voluntarist. That is the heart of the matter.Monetary policy is not the result of an ideas debate or a clash of personalities. It is the product of accumulated imbalances.When debt is too high, when assets are overvalued on credit, when the long term is financed with short-term funds, when the economy depends on a permanent flow of liquidity, the central bank no longer really has a choice. It can delay the adjustment, disguise it, even deny it for a time. But it cannot eliminate it.

Warsh will very quickly discover, as Powell did before him, that the room for maneuver is narrow.The markets applauding his firm discourse today will be the first to cry for help if rates rise too much or too quickly. They will then demand, as always, that the Fed return to an accommodative policy to preserve financial stability and prevent a collapse in valuations.

The mistake markets are making is believing that the personality of the Chair changes the nature of the problem. It changes nothing. The problem remains material: an over-indebted, financialized economy dependent on low rates and abundant liquidity.As long as these structural conditions—such as the lack of savings, for example—are not resolved (and they will not be by a mere change of tone at the Fed), monetary policy will remain constrained.It will be imposed by facts, not chosen by men.

The voluntarism of this or that individual will change nothing.

Economic materialism, for its part, remains inflexible.

My analysis of Warsh’s intervention is not reassuring. It leads me to believe that he has not yet truly grasped the extent of the imbalances in the American system.

My conviction is reinforced by the dystopian behavior of the stock market: it welcomed Warsh’s remarks positively when it should have collapsed if it truly believed them!Markets listened to Chair Warsh’s speech while categorically rejecting the possibility that the Fed would genuinely tighten financial conditions.The S&P 500 rose nearly 1% last week. The Nasdaq 100 climbed 2.6%. The semiconductor sector surged 7.3%!

I remind readers that the rate hikes to 5.5% (before the easing of September 18, 2024) did not succeed in tightening financial conditions.To master current inflation—both asset-price inflation and goods-and-services inflation—policy rates would need to be significantly higher, perhaps even 6% or 7%. Markets, in their unconscious, know that the Fed will not dare consider such an approach, which would risk bursting the speculative bubble.

The following exchange definitively nails my analysis for me. Warsh is operating in the realm of the desirable, not the possible.

Warsh is not situated in the real universe; he is telling us what should be done in the abstract but what precisely can no longer be done: realigning the imaginary of markets with real economic data.

He is therefore in a universe of post-reconciliation between finance and economic reality, without telling us how to move from one to the other—how to exit the financial imaginary of bubbly false values without crashing.

Edward Lawrence, Fox Business:

“If you don’t provide clear and regular guidance about the future, won’t markets become more volatile? And shouldn’t Americans have better access to your intentions?”

Kevin Warsh: “I think financial markets function better when they respond to economic data. They are less effective when they ask: ‘How will the Federal Reserve react to this new information?’ The more markets focus on the real economy and evaluate the relevance of the data, the better they can anticipate the most probable scenarios and tail risks.

Financial market prices are probably the most important source of information to guide central bankers.But when financial markets merely reflect our statements, we miss this essential source of information.

I want us to create a system where this blindness disappears, where markets base themselves on data they judge reliable, where we monitor the data together, and where prices provide us with more relevant information.

We can then make better-informed decisions, with the ultimate objective I set from the beginning: ensuring price stability in accordance with the directives of Congress. And that is what we must do.”

Kevin Warsh makes a good diagnosis—and that is normal, since he was outside the system and did not bear operational responsibilities! He was a bit like opposition politicians who have an easy time criticizing those who actually exercise practical responsibility.

Wall Street and the Federal Reserve have been sleeping together for decades; they are locked in a dysfunctional relationship of mutual delight. A central bank should avoid entering into a perverse relationship with the stock market and finance, but that was before—before Greenspan, before the Maestro ennobled by the Queen of England.

As Ray Dalio—and I—have said, we are at the end of a long credit cycle that began after the Second World War. This cycle produced a new economic system: progressively financialized, doped with abundant and cheap money.

Everything has changed, adapted, and structured itself around the abundance of money and its low price. Everything has adjusted to risk-taking without sanctions. Markets ignore a multitude of risks, including a worrying potential inflation. These markets are confident that the Fed will not take the risk of bursting speculative bubbles. They are pricing in relatively low policy rates and accommodative monetary conditions.

Re-reading Warsh’s response to a pertinent Bloomberg journalist, I go much further than anything I have said so far; I dare to write that Warsh is a clown!

The future cannot be predicted, but sometimes we can see the present with the eyes of tomorrow!

Analyze this response: a monument of evasion!

Enda Curran, Bloomberg:

“Could you please explain some of the principles that guide your own reaction function, and tell us a bit about the conditions under which, in your view, the Fed should react?”

Kevin Warsh:

“My answer to the last question will be very unsatisfactory. The Federal Reserve has many responsibilities, not only in monetary policy but also in supervision and regulation, consumer protection, and payments.

In my view, our credibility rests on our ability to deliver on our commitments across all these areas. I have spent more time on monetary policy than on all these other subjects during my first three weeks. But the more we deliver on our promises as good supervisors and good regulators, the more we will benefit, and the more our credibility in monetary policy will be strengthened.

When we achieve our price-stability objectives—which we will—the American people will feel that the difficulties they have endured over the past five years, partly because of inflation, now belong to the past, and this credibility will bear fruit in all our actions.”