Fed Officials Remain Wary of Changing Funds Rate, But Inflation Concerns Paramount

— Balance Sheet Policy Due To Come Into Focus As Warsh Takes Charge

By Steven K. Beckner

(MaceNews) – As the Jerome Powell era gives way to the Kevin Warsh regime at the Federal Reserve, Fed officials continue to warily contemplate whether the U.S. central bank’s short-term interest rate settings need to be adjusted.

For now, they seem content to leave the federal funds rate where it is, but increasingly they are eschewing rate cuts and becoming more willing to consider rate hikes if inflation does not subside.

Technically, Powell is still chairman pro tempore until Warsh is sworn in by President Trump on Friday, having been confirmed by the U.S. Senate on May 13, but in reality it is no longer Powell’s central bank to run, even though he is staying on the Board of Governors for the time being. And speculation is rife about how monetary policy and other Fed activities will change under Warsh’s leadership.

He will chair his first meeting of the Fed’s policymaking Federal Open Market Committee June 16-17, and despite his past support for lower interest rates, virtually no one expects him to extract a rate cut at that meeting, with inflation on the rise amid oil market disruptions of the Iran war.

In the meantime, Fed officials remain in a cautious, wait-and-see mindset.

Richmond Federal Reserve Bank President Tom Barkin said Thursday that monetary policy is “well-positioned to respond as appropriate.” to risks to the Fed’s objectives. He said the key to whether the Fed can “look past” the recent spike in energy costs is whether or not long-term inflation expectations stay “anchored.”

Philadelphia Fed President Anna Paulson echoed many of her colleagues Tuesday in saying the current “mildly restrictive” monetary policy is “appropriately positioned” and gives the FOMC time to assess risks to the Fed’s “dual mandate” goals of maximum employment and price stability.

So long as labor markets “remain in balance,” she said she could only envision rate cuts if there is “sustained progress on inflation,” and she said it is “healthy” for financial markets to take “on board” the possibility of rate hikes.

Both Barkin and Paulson put more emphasis on upside risks to inflation than to downside risks to employment.

At its last meeting, April 28-29, the FOMC left the funds rate in a target range of 3.5% to 3.75% on April 29. But there were an unusual four dissents, with departing Governor Stephen Miran wanting an immediate rate cut and three Federal Reserve Bank presidents wanting to ditch the easing bias contained in the “forward guidance” paragraph of the FOMC statement.

The majority voted to retain this sentence: “In considering the extent and timing of additional adjustments to the target range for the federal funds rate, the Committee will carefully assess incoming data, the evolving outlook, and the balance of risks.” By referring to “additional adjustments,” as it had following the last of three rate cuts on Dec. 10, the FOMC leaned toward a resumption of rate cuts at some point.

Only Cleveland Fed President Beth Hammack, Minneapolis Fed President Neel Kashkari and Dallas Fed President Lorie Logan voted to drop that “easing bias.” But minutes of the last FOMC meeting revealed that “many participants” wanted to drop the easing bias. Powell said a shift to a “neutral” statement could be an intermediate step toward adopting a tightening bias that could set the stage for an actual rate hike.

The minutes reported that “participants generally judged that the continued elevated inflation readings together with uncertainty related to the duration and economic implications of the Middle East conflict could necessitate maintaining the current policy stance for longer than previously anticipated.”

There was a definite shift in sentiment in the direction of tighter policy, according to the minutes.

While there were “several participants” who thought “it would likely be appropriate” to lower the funds rate “once there are clear indications that disinflation is firmly back on track or if solid signs emerge of greater weakness in the labor market,” most leaned in the other direction.

“A majority of participants highlighted, however, that some policy firming would likely become appropriate if inflation were to continue to run persistently above 2 percent,” the minutes say. “To address this possibility, many participants indicated that they would have preferred removing the language from the post -meeting statement that suggested an easing bias regarding the likely direction of the Committee’s future interest rate decisions.”

In their discussion of “risk-management considerations,” the minutes say, “Participants generally observed that the conflict in the Middle East could have significant implications for the balance of these risks and for the appropriate path of monetary policy.”

“Several participants indicated that, in a scenario in which the conflict was resolved soon, rate reductions would be warranted later this year if the effects of higher tariffs and energy prices on inflation were to dissipate in line with their expectations.”

But here too there was movement away from easing. “Some participants expressed concerns, however, about a scenario in which sustained elevated energy prices, combined with the effects of tariffs, could result in inflation pressures becoming embedded more broadly, potentially de-anchoring inflation expectations and creating a greater tradeoff between the Committee’s employment and inflation goals.”

But all of that happened before the reputedly more “dovish” Warsh took over, so it remains to be seen how his leadership will guide FOMC communications.

Since the late April FOMC meeting, an array of Fed officials have variously called monetary policy “well-positioned” and “in a good place,” but there has been an unmistakable drift away from making monetary policy more accommodative.

Barkin, who will return to the FOMC voting ranks next year, defended the FOMC’s stand pat decision at the last FOMC meeting, saying, “it made sense to give ourselves some time before setting sail.”

He was ambiguous about what the FOMC’s next move should be and when. “Going forward, I wouldn’t be surprised if we continue to see rough seas that pressure the employment side of our mandate, the inflation side of our mandate, or conceivably both.”

“If we do, the Fed is well positioned to respond as appropriate,” he added.

But Barkin expressed more concern about inflation than about potential weakness to economic activity and employment.

“The U.S. economy remains remarkably resilient,’ he said in remarks to ULI Triangle Capital Markets in Raleigh, noting that “consumer spending is up, and not just due to ever more expensive gasoline. Non-gas spending growth has remained solid, too.”

Barkin said “the extent of (the Iran war’s) impact will depend on how long it lasts and how long it takes to rebuild supply chains and manufacturing capacity.”

He made clear he is more worried about the inflation outlook, noting that headline PCE jumped up to 3.5% year–over–year in March 2026, while even core inflation increased to 3.2%.

Like others, Barkin said that, “Conventional central bank wisdom says the Fed should look past supply shocks.” After all, “raising rates to weaken demand doesn’t address the root cause behind supply shock-driven inflation…..”

But it’s not that simple, he suggested. Much depends on whether inflation expectations are under control.

In the past, he said “looking through supply shocks has worked well for a generation thanks to what economists call ‘anchored long-term inflation expectations.’”

“When these expectations are “anchored,” consumers understand that temporarily elevated inflation does not mean sustained inflation in the long term,” he elaborated. “They won’t negotiate for an outsized increase in wages because they don’t expect outsized increases in rent, groceries, and other expenses to persist. They won’t feed inflation by preparing for perceived inflation to come.”

But these days, Barkin said he has “been asking myself whether we’ve entered an era where supply shocks will become more frequent” and inflation expectations become unhinged.

“If that occurs, does the Fed have the luxury of riding out all the waves that come our way?” he asked rheotricaly. “For me, it comes down to how much businesses, consumers, and inflation expectations can take…”

Already, Barkin said, “the recent increase in gas prices has understandably increased near-term inflation expectations….”

So far, he said “measures of forward inflation compensation beyond the next year and survey-based measures of long-term inflation expectations remain well anchored.”

But he added, “With inflation above our 2% target for over five years now, it’s worth asking whether the cumulative impact of so many waves risks loosening the anchor.”

Barkin also asked two other questions: “will businesses get queasy?” and “will consumers abandon ship?”

He said “the answers to those three questions will determine whether the Fed still has the luxury to look through supply shocks.”

Paulson echoed the view that policy is okay for now, but offered up scenarios in which the FOMC might have to keep policy “restrictive” or perhaps make it more restrictive. She had a higher hurdle for monetary easing.

“I believe monetary policy is appropriately positioned to navigate current challenges,” she told the Atlanta Fed’s annual Financial Markets Conference. “Policy is mildly restrictive and that restrictiveness is helping to keep inflation pressures in check while the labor market remains stable.”

Paulson, a non-voter, strongly suggested there is no need for additional monetary stimulus at a time when “inflation is too high,” while “the labor market continues to be pretty stable; the consumer is resilient; and we are seeing solid growth, bolstered by investment in AI infrastructure.” She projected that real gross domestic product (GDP) will grow by 2% again this year.

“While many families are feeling stretched by inflation, there are few signs that consumers are pulling back sharply in the aggregate,” she said.

Looking at the labor market, Paulson observed that “the unemployment rate has been remarkably steady and near what I consider to be full employment for many months,” and said her “base case is that the labor market will remain stable and that we will end the year with an unemployment rate in the range that has prevailed over the past few years.”

She was much less sanguine about inflation.

“Inflation is too high,” Paulson asserted. “Multiple forces have kept inflation elevated. Most recently, tariffs and the spike in energy and commodity prices associated with the conflict in the Middle East are pushing inflation higher.”

Noting that inflation, as measured by the price index for personal consumption expenditures, was 3.5% in March, she said “last week’s data on consumer and wholesale prices for April point to continuing pressures as oil and gas prices rose further.”

Calling both tariffs and Middle East disruptions “classic supply shocks,” Paulson said “conventional wisdom” would call for the Fed to “look through” those shocks. But she suggested that might be unwise if there are “forces in the economy now that could amplify these supply shocks and lead to broader and more lasting inflationary pressures.”

She focused on three factors: “the strength of economic activity; inflation expectations, and the stance of monetary policy.

On the first, Paulson said “GDP is growing at roughly potential, the labor market is approximately in balance, and wage growth is consistent with 2% inflation,” then concluded that “the pace of economic activity does not appear to be adding materially to inflationary pressures.”

As for inflation expectations, she warned, “If households and businesses anticipate that supply shocks will leave a lasting impact on inflation, then monetary policy might need to be tightened to align inflation expectations with our 2% goal.”

“After five years of elevated inflation and a series of supply shocks, this is a real concern,” she continued, but she added that “currently long run expectations are in a good place.”

Paulson said she would be “more worried that the supply shocks we are experiencing could lead to persistent inflation” if monetary policy were accommodative, but she said “monetary policy is mildly restrictive and that restrictiveness is helping to keep the effects of both tariffs and the price increases associated with the conflict in the Middle East in check.”

“Taking these three factors together, I believe the current stance of monetary policy is appropriate,” she went on. “While there are certainly risks, for now, monetary policy, economic forces and inflation expectations are all helping to keep price pressures from tariffs and the conflict in the Middle East from turning into a more lasting inflation problem.”

So Paulson said she believes “monetary policy is currently well-positioned to balance the risks that I’ve described and to react if the risks become manifest.”

But she didn’t rule out the need for rate adjustments to contain inflation, in line with market expectations.

“Right before the April FOMC meeting, markets were anticipating perhaps one rate cut this year,” Pauslon recalled, but “more recently, expectations have shifted to incorporate the possibility of steady rates or even a modest tightening.”

Right now, she said, “monetary policy is in a good place now. Keeping rates steady allows us to assess how the economy is evolving and the risks to both price stability and the labor market. Assuming the labor market remains in balance, rate cuts would only become appropriate once we have seen sustained progress on inflation.”

“However,” Paulson added, “I think it is healthy that market participants have taken on board scenarios where the funds rate remains unchanged for an extended period, as well as scenarios where further tightening becomes necessary.”

She said she “expect(s) the labor market will remain stable and that inflation will gradually return to 2% as the effects of recent shocks fade,” but she said “risks to inflation have increased and the timing and pace of any policy adjustments will be determined by the incoming data.”

Pauslon warned that “other scenarios are certainly possible. If the conflict in the Middle East is resolved soon and shipping and oil production return to normal quickly, inflation and inflation risks are likely to subside relatively quickly. If it takes more time to resolve, inflation and inflation risks, along with risks to the labor market, are likely to be elevated for longer.”

Meanwhile, in the quantitative realm of monetary policy, differences of opinion are emerging on Warsh’s goal of shrinking the balance sheet – how to go about it and whether to do it at all.

At $6.5 trillion, the Fed balance sheet is down considerably from its 2022 peak of $8.9 trillion after three years of “quantitative tightening,” but it remains far below the $800 billion which it averaged before the Fed began large-scale asset purchases or “quantitative easing” in 2008 during the Great Financial Crisis and again during the Covid pandemic.

The Fed ballooned the balance sheet by creating money — “printing money” as then-Chairman Ben Bernanke openly called it –to buy massive amounts of Treasury and MBS securities and building up bank reserves in the process.

On Dec. 10, along with its last 25 basis point rate cut, the FOMC not only stopped shrinking the balance sheet, it resumed slowly expanding it by launching so-called reserve management purchases (RMPs) of shorter-term Treasury securities “as needed to maintain an ample supply of reserves on an ongoing basis.”

Enter Warsh, who has made no secret of his desire to substantially reduce the size of the balance sheet, in large part to insulate monetary policy from fiscal policy.

“In my judgment, we should be shrinking the central bank balance sheet, taking the Fed out of these markets unless and until there’s a crisis,” he said in an interview with the Hoover Institution’s Peter Robinson last July. “And in so doing, you’d have less inflation that way.“

When he was a Fed governor from 2006 to 2011, Warsh supported the first round of quantitative easing or “QE1,” but became increasingly disillusioned with the whole exercise as the Fed kept ballooning its bond portfolio with QE2 and QE3, then later a fourth round during Covid. He sees Fed bond buying as “subsidizing” deficit s[ending and the U.S. Treasury’s debt financing.

“When the Federal Reserve prints trillions, especially in benign times, it changes everything,” he said, “and it almost is a signal to the rest of Congress we’re doing it and so can you.“

Recalling the FOMC’s launching of QE, Warsh said, “QE sort of took off without us. And what did we say then? We debated internally whether to do this. And the story goes something like this: (Treasury) Secretary Paulson, he’s issuing bonds on Monday and Tuesday. What do you say we buy them on Thursday and Friday?”

Warsh said he “supported” QE1 “with many colleagues under the view of we’re gonna put this very dangerous, risky stuff back behind the covered glass until there’s another crisis. We really never did that.”

“Subsequent QEs (were done) during a period that I would say was reasonably strong growth, reasonably stable financial markets, reasonable periods of stable prices,” he said. “We start doing it for all seasons and all reasons, and in so doing we raise the bar for when another crisis hits.”

Warsh contended that the expansion of the Fed’s balance sheet through QE led to fiscal recklessness and to higher inflation.

“We didn’t have an emergency for most of the decade between 2010 and 2020,” he said. “This was the time for the Central Bank to retreat, instead, the Central Bank stayed on the front pages.”

Instead of shrinking the balance sheet after the crisis had passed, the Fed declined to do that, so “Congress said, well, if the central bank are buying all the bonds, then we can spend trillions,” he said, “Hence the fiscal authorities, Congress and the President decided there are very few costs to all of this spending, because the Federal Reserve is subsidizing it, because we were the most important purchaser of these bonds.”

Warsh warned that if the Fed does not change its quantitative monetary policy, it could face more difficulties in the future. “If you treat every day for more than a decade like it’s a crisis, then when the actual crisis hits, you have to cross more lines. You have to get more involved in the private sector.”

Warsh went on to draw a direct line between the Fed’s QE bond buying and the inflation upsurges. “If we would run the printing press a little quieter, we could then have lower interest rates because what we’re doing right now is we have all this money that’s being flooded into the system which causes inflation to be above target.”

He said the balance sheet has to be seen as more of a monetary instrument in conjunction with the federal funds rate target. “They’re not perfect substitutes for each. But they’re both monetary policy and too many that are in the central banking business say no, no, no, that balance sheet has nothing to do with monetary policy…. . I think we have to be honest about these two instruments.”

“Because you have higher inflation caused by the bigger balance sheet, we wanna shrink that,” Warsh went on. “We can’t do it overnight.”

He advocated a new “accord” between the Treasury Department and the Federal Reserve that would outline “Who’s responsible for what? Who’s going to be managing interest rates? The Federal Reserve. Who’s going to be handling fiscal accounts? The Treasury Department.”

Warsh complained that, “We have blurred these lines about who’s responsible.” .

Changing the Fed’s balance sheet policy and the operations surrounding it may not be so easy, though.

For one thing, there is apt to be a certain amount of institutional inertia, not to say resistance.

Since it began ballooning its balance sheet —  “printing money” as then-Chairman Ben Bernanke openly called it to buy massive amounts of Treasury and MBS securities and building up bank reserves in the process — the Fed has become heavily invested in a whole new operational apparatus to support what it has called its “ample reserve regime” since 2019.

To encourage banks to hold more reserves, it began paying interest on them. Reserves represent nearly half of the Fed’s liabilities, the rest being currency in circulation and the Treasury General Account, the U.S. Treasury’s account with the Fed. On the asset side of the balance sheet are Treasury securities and agency mortgage-backed securities.

Financial institutions that are ineligible to earn interest on reserves, principally GSEs (government sponsored enterprises like Fannie Mae) can earn income from the Fed by resorting to a facility which the Fed created in 2014 — Overnight Reverse Repurchase Agreement Operations (ON RRP), in which the Fed sells a security to an eligible counter-party and simultaneously agrees to buy the security back the next day.

The interest rate on reserve balances (IORB) sets a benchmark against which banks evaluate their lending and borrowing opportunities. The interest rate on the overnight reverse repo facility (ON RRP) helps provide a floor for overnight money market rates.

To set a ceiling for the funds rate, the Fed in 2021 created another facility — Standing Repurchase Agreement Operations (SRP) — to supply liquidity to eligible counter-parties and thereby limit upward pressure on overnight money market rates to support monetary policy implementation and smooth market functioning. When the Federal Reserve conducts an overnight repo, it buys a security from an eligible counter-party and simultaneously agrees to sell the security back the next day. The difference between the purchase price and the sale price of the securities implies a rate of interest earned by the Federal Reserve on the transaction.

Overlaying these tools is a key regulation – the Liquidity Coverage Ratio (LCR) — that requires the largest banks to hold sizable amounts of “high quality liquid assets” (HQLAs), that is Treasury securities, to help them weather stressful financial scenarios. This has created another incentive to build up reserve deposits at the Fed.

This elaborate superstructure, built to backstop the “ample reserves’ system, would presumably need to be changed if the Fed were to revert to the former “scarce” reserves system, when the New York Fed open market trading desk added or drained reserves to hit the FOMC funds rate target.

Even the idea of shrinking the size of the balance sheet (and reserves) has raised some hackles.

Last Thursday, for example, Gov. Michael Barr strongly objected to the incoming Chairman’s plan, without mentioning him by name.

“I think shrinking the balance sheet is the wrong objective, and many of the proposals to meet this objective would undermine bank resilience, impede money market functioning, and, ultimately, threaten financial stability,” he told the Money Marketeers of New York University. “ Some would actually increase the Fed’s footprint in financial markets.“

Barr contended that, “first, the size of the Fed’s balance sheet is the wrong measure of the Fed’s footprint in financial markets, and, second, many of the proposals being floated to address this purported problem would make our monetary policy operations less efficient and effective and raise financial stability risks.”

He alleged that “some proposals would increase the frequency of Fed lending and transactions in markets, both to implement monetary policy on an ongoing basis and, in extremis, to engage in interventions to preserve financial stability.”

Besides, Barr “see(s) monetary policy implementation today as efficient and effective.”

Warning against reducing reserves, he said, “If banks don’t have enough reserves, the payment system suffers, because it gives them an incentive to economize on their liquidity by slowing down their outgoing payments, leading to bottlenecks and stresses in funding markets.”

Barr objected to reducing demand for reserves by, for example, relaxing the biggest banks’ Liquidity Coverage Ratio, and to reducing the size of Treasury deposits at the Fed.

Summing up, he declared that “shrinking the Fed’s balance sheet is the wrong goal, and reducing the resilience of the banking system is the wrong means.”

But the man in charge of managing the System Open Market Account at the New York Fed, Roberto Perli, sounded more amenable to changing the way the Fed does business in a Tuesday speech to the Atlanta Fed’s annual Financial Markets Conference.

In coolly analytical remarks, he suggested the New York Fed has the needed flexibility to implement monetary policy with a smaller balance sheet, if asked to do so.

“While the current implementation framework is demonstrably very effective, there is an active public debate about the quantity of reserve supply that it entails.” Perli said. “Conceptually, if policymakers wanted to reduce the supply of reserves and therefore the size of the Federal Reserve’s balance sheet, they have two broad approaches at their disposal.”

“The first is to take steps to reduce banks’ demand for reserves and thereby reduce the quantities of reserves consistent with the ample range,” he continued. “We can think of this as shifting the reserve demand curve leftward…. . The second approach is to move up along the demand curve…. that is, reduce reserve supply so that reserve conditions approach scarcity (or potentially even cross into scarcity, in which case the monetary policy implementation framework would change).

Perli went on to say that “the current ample reserves implementation framework is well equipped to handle a reduction in the SOMA portfolio through a leftward shift in the reserve demand curve.”

Pointing to the Fed’s various policy tools, notably the ON RRP facility, he said, “If reserve demand diminishes and reserve supply remains the same or increases via RMPs, there will be an imbalance between demand and supply of reserves, and that imbalance will be reflected in money market conditions just like it was when reserves were abundant.”

“Depending on the specific source of the decline in reserve demand and the channels of transmission, it could be that the federal funds rate will soften, repo rates decline significantly, ON RRP usage increases, or that Federal Home Loan Bank advances will decline, or that a number of other market conditions will change,” he continued. “Regardless, some of the market indicators and survey data we collect and monitor will pick up the change; at that point, depending on the extent of the change, the Desk would be in a good position to adjust downward or stop the pace of RMPs or advise the Committee on the opportunity to resume balance sheet runoff. In this hypothetical but plausible situation, reserves would be lower than in the absence of a shift in demand, but rate control would stay strong and money market conditions would remain stable because reserve supply would still meet demand.”

Perli added that “our current ample reserves framework would handle the task seamlessly,” but “it is not the only possible efficient implementation of an ample reserves system.”

He said “there are many possible catalysts for a leftward shift in reserve demand, but a plausible one given the current debate is through potential future changes to bank regulatory liquidity requirements.”

Perli said “reserves could also decline without a shift in the reserve demand curve—the FOMC could simply decide to supply a lower quantity of reserves and move the financial system along the existing curve.”

Were the FOMC to take that approach, he acknowledged that “money market rates would move persistently above IORB,” and “higher money market rates would likely be accompanied by higher volatility” and “more risks in terms of rate control and funding market stability.”

However, Perli said the New York Fed could cope with those potential repercussions.

For example, he said, Standing Repurchase Agreement Operations (SRPs) “ are a critical tool to ensure that the federal funds rate remains within its target range even on days of elevated pressures in money markets. As such, they are intended for the sole purpose of supporting monetary policy implementation, and they are expected to be used when economically sensible—that is, when market rates climb above the SRP rate.”

Perli concluded by saying that if reserve demand declines for any reason, the Fed’s Reserve Management Purchases (RMPs) “can be adjusted downwards or even stopped; in that case, the SOMA portfolio will shrink relative to GDP. If a decline in reserve demand is sufficiently pronounced, the SOMA portfolio can decline even in absolute terms. Either way, an ample reserves implementation framework is well equipped to handle these potential changes, especially if standing repo operations are used when economically sensible.”

At this stage, the FOMC is only beginning to think about these things, as the Committee awaits Warsh.

Few were contemplating permanent abandonment of the scarce reserve approach to monetary policy when the Fed started blowing up its balance sheet. But after a decade of expanding the Fed’s bond portfolio, the Fed staff and policymakers decided to make a virtue out of necessity and switch to an “ample reserves” regime.

Now that balance sheet reform is on the table, it will be difficult to go back to scarce reserves, and not just because of internal opposition. But, at least in the early going, it doesn’t have to be one way or the other — all or nothing. More likely is a compromise approach in which the Fed gradually shrinks the balance sheet, while continuing to use its tools and facilities to manage it.