‘he Will Bring Some Fresh Air’: Mohammed El-erian On Kevin Warsh

In selecting Kevin Warsh to lead the Federal Reserve, President Donald Trump has taken a much different tack than many Wall Street CEOs and Fed watchers may have assumed.

As a former Fed governor and Wall Street banker, Warsh was fixated on threats posed by surging prices and artificially cheap financing costs — which suggests that he’s cautious about cutting rates too quickly. That view runs counter to Trump’s insistence that Powell’s replacement swiftly bring down short-term interest rates — which risks over-stimulating a fast-growing economy that’s still wrestling with elevated inflation.

Over the last year, Warsh has said that he agrees with Trump’s view that borrowing costs should fall, but he’s also argued against the Fed’s prior interventions in markets to spur growth, and that its “bloated” balance sheet led to financial excess. By contrast, another finalist for the job — BlackRock Global Fixed Income CIO Rick Rieder — has expressed more openness to such interventions.

To gauge how Wall Street was parsing Trump’s choice, I reached out to Mohamed El-Erian, a famed economist and a colleague of Warsh’s at the Group of 30 who has a large following in the financial sector. El-Erian has argued that current Fed chair Jerome Powell waited too long for economic data to come in before acting, and that the biggest change Warsh may bring is to be a little quicker out of the gate.

“Monetary policy, by definition, has a certain amount of a lag, and you have to have a forward-looking view,” El-Erian said. “The Fed didn't engage in that forward-looking view. And I think what's going to happen now is that he's going to bring fresh air into the institution.”

This conversation has been edited for length and clarity. 

What signal does this pick send to Republican senators, market participants or CEOs when it comes to central bank independence?

I think it sends a good signal. I think that President Trump has selected someone who has deep expertise. He has broad experience, including the Fed. He's a good communicator, and he recognizes that reforms to the Fed are needed to make it more effective.

Without reforms, the Fed’s independence would be at risk. And [Warsh] recognizes that we need an approach to balance sheet management, we need to restore better communication, we need strong accountability. He’s someone who understands that you need to strengthen and modernize this institution to make sure that it is more effective and — importantly — it retains its political independence.

The Fed’s rate-setting committee has been quite divided, at least compared to recent history. Warsh is going to have to craft a pretty strong narrative to convince other committee members of his view of the economy. How do you think he’s going to manage that? 

Kevin inherits three major challenges. One — a divided Fed. There are opinions all over the place in this Fed right now. Two — a Fed that is protecting its political independence. And three — a Fed that has been so data dependent for so long that it has weakened its strategic muscle.

What I suspect he will try to do is address all three by trying to get agreement on the strategic view of the economy. Alan Greenspan did this, Ben Bernanke did this, and Janet Yellen did this. And all three of them had the credentials to do so. They were economics PhDs, etc. Kevin comes into a Fed that has really not used that muscle [recently]. They've only used the data-dependent muscle.

I think he will try to overcome those three challenges by trying to get consensus on the strategic view. It's probably going to take time. Incoming Fed chairs have to assert their authorities on the committee. This committee is particularly divided, and it's a tricky time for the economy.

Fed policymakers have largely been resistant to the president’s demands and pressure tactics. Do you think Warsh will have a harder time asserting that authority, given the fact that he just went through a selection process where the president gave explicit direction on how the next Fed chair should set rates? 

There is a big hurdle, which is his nomination in front of the Senate. That's a serious one. Unless two senators decide to change their mind, it's going to be difficult to get this through — that has to do with the Powell investigation — so that is an immediate challenge.

[If he’s confirmed this spring], his first [rate-setting] meeting will be in June. And if the markets are correct, there will have been no interest rate cuts between now and June. At that point – in my opinion — we will have a weak enough labor market to be able to get consensus on a rate cut.

Do you think he’ll have the backbone to oppose Trump if they think rates should move in opposite directions? 

I do.

Warsh has a hawkish reputation on inflation — which usually would suggest higher rates. The president has been very specific in saying that this next Fed chair will deliver lower rates. How do you see his track record squaring with what the president wants? 

Warsh will deliver lower rates if he is correct that the transformations in AI and other innovation results in higher productivity that will increase the non-inflationary growth rate of the economy.

It’s not that he's against lower rates. He wants to see the supply side improvement that would increase the speed limit of non-inflationary growth.

There’s a flipside to that. Productivity can mean fewer workers producing more stuff. And if we’re moving into a lower payroll growth environment, that tends to lower wage growth, and that has political consequences. Wouldn’t that put more pressure on Warsh and the Fed to cut beyond what the speed limit allows? 

As I said, if we get adoption right.

GDP growth has decoupled from employment growth. We had a 4.4 percent growth rate in the third quarter. We are probably going to get a 4 percent growth rate in the fourth quarter — that number comes out in a couple of weeks. Meanwhile, employment and the labor market has been relatively weak. If that decoupling gets worse, it will complicate the job of the Fed.

But if [Warsh] doesn't lower interest rates, certain interest rate-sensitive sectors like housing, for example — which is labor-intensive — would not benefit. In a perfect world, you get the productivity improvement from AI [and] you get lower rates that allow you to support the housing market.

Given the forces that may impact the labor market and growth, do you think that’s going to put the Fed or Warsh in a position to weigh in on AI policy and AI adoption? 

Chair Powell didn't want to engage on fiscal policy. He didn't really want to engage on AI policy. They've done very little work — that I know of — on looking into the impact of AI on productivity and growth and therefore on monetary policy.

I think that he will bring some fresh air into the institution. The [Fed] became very data dependent after the big mistake of 2021, when inflation was [mistakenly viewed] to be transitory and went all the way up to over 9 percent for CPI inflation. The Fed leaned away from any strategic view of the economy, and they became totally data dependent — ‘we will see where the data will take us’ — but monetary policy, by definition, has a certain amount of a lag, and you have to have a forward-looking view.

The Fed didn't engage in that forward-looking view. And I think what's going to happen now is that he's going to bring fresh air into the institution to talk about these issues.

Going back to the balance sheet, Warsh has described the Fed’s use of its balance sheet as mission creep. So has Secretary Scott Bessent. How do you see those views syncing up? 

That was a big difference between him and Rick Rieder … Rick Rieder believes in a much more active use of the balance sheet, and Kevin is uncomfortable with a large balance sheet. He believes that a large fed balance sheet distorts markets.

What he thinks — and he's not the only one — is that we should have a theory of the balance sheet. We should have a view on what is an optimal balance sheet, just like we have a view on what is a neutral interest rate. A neutral interest rate — by definition — is the optimal rate, but we don't have a view on what is the ultimate balance sheet.

I suspect that when he comes in, he will push for a lot of work on what is the optimal balance sheet of the Fed. And his inclination — from what I've read — is that the Fed balance sheet is still too large and that it interferes with the functioning of markets.

Does that view align with Bessent’s on how the balance sheet should be reformed? Warsh has previously called for a new agreement between Treasury and the Fed to better coordinate on its balance sheet. Do you expect them to work more hand-in-glove? 

There's a very important line between independence and collaboration. Some people, the minute you say collaboration, they’ll say: ‘Fiscal dominance, we don't want to go there.’ But you can be an independent central bank and you can come to the table to collaborate on overall economic policy.

Similarly — and I'm glad that Chair Powell finally acknowledged it on Wednesday — an independent central bank has to be an accountable central bank. It can't be just a central bank that goes and does whatever it wants and isn’t held responsible for its mistakes. That is really important. Yes, he will be more open to collaboration with other economic agencies — including Treasury — but importantly, he will also preserve the independence of the Fed.

The simple view is that a smaller balance sheet tightens monetary policy. Trump is adamant about wanting looser financial conditions. How does Warsh’s likely desire to bring down the size of the balance sheet square?

When you expand the balance sheet for market malfunction — as we did this in 2008-2009, and we did this in 2020 — it is incredibly powerful.

But what we discovered is that the other way of using QE [quantitative easing], to stimulate the economy — which is the way Bernanke’s Fed pivoted in 2010 — it’s less powerful. The theory is: You go out, you expand the balance sheet, you buy assets. As these assets go up in price — because you are demanding more of them — the price goes up. As the price goes up, the wealth goes up. As the wealth goes up, that triggers a wealth effect. People, when they look at their 401ks, see that they're richer and they go and spend more.

QE certainly pushed up asset prices, but didn't push up economic activity at all. And when you push up asset prices, you start encouraging all sorts of resource misallocation. Zombie companies can issue bonds because the cost of borrowing has become so low.

Will [shrinking the balance sheet] tighten financial conditions for asset markets? Yes, they will. They absolutely will. But it's not clear that you will tighten financial conditions for the real economy.

Warsh was a big conduit between the Fed and Big Banks during the global financial crisis. He’s a Wall Street guy. How do you think the economic populists in Trump’s coalition will respond to this pick? 

I'm not sure. Rick Rieder would have been worse, right? He works for a [multi]-trillion asset manager at BlackRock. Maybe Kevin Hassett wouldn’t have that [problem], but then Kevin Hassett would have been viewed as being too close to Trump.

We live in a world where you always get criticism. You will get two criticisms [of Warsh]: You'll get one [that’s]: ‘He is central casting. He's not someone who’s close to the people.’ Something like that. He’s Stanford, Harvard, Fed, financial sector. There will be people who criticize him simply because of that.

Others will criticize him for [coming] out very strongly in the last few years to complain about the Fed having missed the inflation pressure that left us with an affordability issue today.

There will be people who would criticize him on those two fronts. But I suspect there'll always be people who criticize something.