Mr. Warsh has just been nominated as Fed Chairman by President Trump. If he acts on his old convictions, he will be an excellent choice, in my opinion.
He was, and apparently still is, against Quantitative Easing and expanding the Fed's role in the broader economy, ie against capital misallocation to support financial markets and to raise asset prices at the expense of productive investments. As I understand it, he is for lower interest rates AND reducing the Fed's balance sheet. I strongly support such actions, particularly the latter.
The Fed is now sitting on $6.5 trillion of assets consisting of Treasury bonds and mortgage securities. While significantly down from $9 trillion at the peak, it is still 600% more than 17 years ago (see chart below).
Federal Reserve Balance Sheet Assets
Some claim that such large holdings are justified because the economy has grown as a whole - but this is only partly true. As we can see from the next chart, assets are now at 21% of nominal GDP, up from 6%.
Assets As Percentage of Nominal GDP
But even this chart is parially wrong: nominal GDP has grown significantly due to inflation, particularly in recent years. So, a better picture can be obtained by looking at the Fed's assets as a percentage of Real GDP, adjusted for inflation (see chart below).
Assets As Percentage of Real GDP
Clearly, the Fed has been adding huge amounts of liquidity into the overall economy. Some of it may be going into productive investments, but judging from the record price levels of risk assets - equities, metals, cryptos, junk bonds and spec real estate - most of it is going into pumping up their prices via easy and plentiful leverage money. Some of it is also directed to more arcane places requiring huge liquidity (eg the Treasury basis trade). In two words: capital misallocation. If Mr. Warsh starts draining this excess liquidity, or at least stops adding to it, there will be significant consequences for all non-productive portfolio assets. Again, two words: Main Street vs. Wall Street. I think the rabid gold and silver speculators got the message loud a clear last Friday.
Mr. Warsh is also a champion of lower interest rates. I have no problem with that as long as he reduces liquidity. Under normal circumstances the Price of money is much less important than the Quantity of money. Hopefully, he will hold firm to his convictions if/when financial markets take a dive and start begging for a bailout.
As a final note, I am no great fan of Mr. Trump, but in this case I applaud his choice.
