Wash's bold gamble: hedging inflation with AI productivity, the Fed's path towards framework restructuring.

More and more senior Wall Street macroeconomists believe that Kevin Warsh, the nominee for Federal Reserve Chairman, faces an almost impossible task - he has to control inflation while also pleasing the U.S. President who nominated him, Donald Trump. The next nominee for Federal Reserve Chairman, Kevin Warsh, believes that a key sign of monetary policy success for the Federal Reserve is when no one talks about inflation anymore. However, in order to achieve this, the nominee for Federal Reserve Chairman may not be able to please the President who appointed him in the short term. Just over an hour before Kevin Warsh began his confirmation hearing in Congress on Tuesday, U.S. President Donald Trump once again made his stance on interest rates clear - he told reporters that he would be very disappointed if the new Federal Reserve Chairman did not immediately lower the benchmark borrowing costs upon taking office. During the two-hour Congressional routine questioning before the Senate Banking Committee, Warsh was very direct in defending the independence of the Federal Reserve and insisted that President Trump did not ask him to make any commitments on interest rate decisions - even if Trump made such a request, he would definitely not agree. What Kevin Warsh truly wants to do may not be a traditional "dove/hawk shift", but a reconstruction of the Federal Reserve's operational framework: on one hand, shrinking the balance sheet, weakening the normalization of QE and quasi-fiscal functions, and on the other hand, using interest rate tools more to support the U.S. real economy and significant productivity improvements driven by the AI wave when conditions allow. Although Warsh has proposed radical reforms such as a "Federal Reserve reshuffle", data scrutiny, and a reevaluation of the Federal Reserve's large balance sheet as part of his reform proposals for the U.S. central bank system, he faces an extremely difficult task in achieving his own profound definition of price stability by the end of this year. Echoing former Federal Reserve chief Alan Greenspan's view on the inflation target, Warsh defines price stability - one of the two duties authorized by the U.S. Congress for the central bank - as a rate of price change that "no one is talking about". In other words, this is the moment when price changes no longer affect the decisions of U.S. households or businesses - when Greenspan initially set 2% as the long-term inflation target, this was the level he envisioned. On the other duty of the Federal Reserve - labor market prosperity, Warsh stated that the U.S. economy is very close to "full employment" for the people. However, to completely dispel concerns about rising prices among businesses and households, it will still take many months, or even years. Currently, oil price shocks have pushed overall U.S. inflation to nearly two-year highs, well above the Federal Reserve's 2% target by more than 1 percentage point. As shown in the figure above, U.S. inflation stubbornly remains above the 2% target point, and is still rising. Before the outbreak of war with Iran, the core inflation index tracked by the Federal Reserve was already more than 1 percentage point above the target. In the coming months, hardly any Americans will stop talking about inflation - or stop taking action because of inflation. According to a recent consumer survey from the University of Michigan, consumers' expectations for U.S. inflation over the next year surged by a full percentage point this month, rising to 4.8%, the highest level of inflation expectations in seven months. And the latest survey by ISM shows that overall input prices for U.S. businesses reached their highest level since the inflation surge in 2022. According to rolling poll data from Ipsos, President Trump's support for dealing with the cost of living issue this month is only 26%, marking his lowest rating on economic issues. The following chart shows President Donald Trump's support on economic issues over time based on Reuters/Ipsos polls. By any measure, the U.S. has not achieved price stability. And if the goal is for "no one to talk about it", then the Federal Reserve is still far from that goal. Warsh says people to stop talking about inflation Of course, Warsh's statement perhaps has a bit of off-the-cuff element, and his wider testimony provides a more insightful analysis of how he views the U.S. economy and how he aims to reform the Federal Reserve's monetary policy framework - perhaps leaving more room for maneuver than the straightforward definition implies. If his nomination is confirmed, the new Federal Reserve Chairman, who will helm the Federal Reserve for at least the next four years, will take over from Jerome Powell next month. He has also mentioned the need to examine issues in inflation data collection, the potential AI productivity wave, forward-looking monetary policy formulation, and gradually reducing the Federal Reserve's large balance sheet, which may free up more space for the interest rate cuts that Trump has long awaited. Despite all these factors potentially laying the foundation for further easing of Federal Reserve monetary policy, the noise from workers and businesses on price issues makes it challenging for him to embark on an easing cycle as desired, defying both reason and his own policy stance. The market is also very aware of this - at least since the recent surge in oil prices. The latest pricing in the interest rate futures market shows that the probability of the Federal Reserve cutting interest rates this year is less than 50%, and expectations for further rate cuts in the next 12 months have not been priced in by the interest rate futures market. Data released on Tuesday showed that U.S. retail sales in March unexpectedly posted the largest year-on-year increase in a year, driven by the surge in gasoline station income under the backdrop of high oil prices catalyzed by geopolitical tensions in the Middle East, and other categories of consumer spending significantly outperforming economists' expectations, highlighting the continued strong consumer spending stance on various goods even as gasoline prices surged due to the war in Iran, with consumer spending accounting for nearly 70% of the U.S. GDP showing strong resilience and continuing to grow. Following the release of the latest retail sales data, traders in the interest rate futures markets have further weakened their expectations for the Federal Reserve to restart an interest rate cut cycle this year. The CME Federal Reserve Watch Tool shows that the majority of traders are betting that the Federal Reserve will maintain the current interest rates throughout the year - before the retail data was released, the market was leaning towards a rate cut. Previous inflation data show that the U.S. CPI rose to 3.3% year-on-year in March, with the core CPI rising to 2.6% year-on-year, and an overall CPI increase of 0.9% month-on-month; as for the PPI data, final demand rose by 0.5% month-on-month and 4.0% year-on-year in March, with a significant 8.5% surge in final demand energy prices month-on-month. Coupled with the unexpectedly strong retail sales data, this implies that the Federal Reserve is facing a typical combination of "short-term resilience in growth, but renewed inflation concerns". In this environment, the Fed's most natural response is not to cut interest rates immediately, but to wait for more evidence to confirm whether the oil price shocks will spread from energy to more widespread core prices and inflation expectations, which is also the core logic behind Deutsche Bank's firm expectation that the Federal Reserve will not cut interest rates at all in 2026. For investors betting on the new Federal Reserve Chairman nominated by Trump to fulfill the White House's desire to lower interest rates, the situation has become more gloomy. Warsh's extensive focus on reducing the balance sheet further tightens this positive picture on the margins. Based on all these factors, it is very likely that Trump will be very disappointed - especially in a midterm election year. As for direct political pressure issues, even if this pressure is not explicitly stated, Warsh's latest view is: "Inflation is a choice, and the Federal Reserve must take responsibility for it." He also added that the government has the right to express its views. "The independence of the Federal Reserve largely depends on the Federal Reserve itself." However, not everyone agrees with this, especially in the legal context of the case against the current Federal Reserve Chairman Powell. The current Federal Reserve Chairman Powell himself has stated that the case is simply an "excuse" for President Trump to force him to further lower interest rates. A statement from former Federal Reserve economist Claudia Sahm on Tuesday was even more straightforward - she wrote, "Warsh's cliches ignore the current reality. The pressure Trump is exerting on the Federal Reserve is far more than just verbal." She wrote, "Central bank officials who oppose Trump's interest rate views not only need to be 'strong enough to listen but not obey' - they also need to be personally wealthy enough to pay the legal fees required when sued for retaliation." If Warsh fails to convince his Federal Reserve FOMC colleagues to accept his grand new vision for the central bank or to stop people from talking about inflation, then the market may not have a long honeymoon period for his monetary policy. More than just cutting rates and reducing the balance sheet! Kevin Warsh bets on AI productivity dividends, aiming to perform a structural surgery on the Federal Reserve The so-called "old framework of Federal Reserve policy" is simply the operational paradigm of the Federal Reserve that has been enhanced since the 2008 financial crisis and further intensified during the pandemic - viewing the ultra-large balance sheet as the norm, gradually transitioning QE and long-term bond holdings from crisis tools into semi-conventional tools, managing market expectations through abundant reserves, forward guidance, and dot plots, while assuming the Federal Reserve can intervene in the Treasury and mortgage markets for the long term. Warsh has clearly criticized this "balance sheet expansion normalization" - he believes it tends to support Wall Street asset prices, distorts market pricing, and increasingly involves the Federal Reserve in quasi-fiscal functions and political controversies. The current size of the Federal Reserve's balance sheet is around $6.7 trillion, lower than the peak of around $9 trillion in 2022, but still significantly higher than pre-financial crisis levels. The new framework advocated by Warsh essentially puts interest rates back at the forefront, reducing the balance sheet to a secondary or even non-conventional tool position. That is, using QE only in the zero lower bound or during major crises, while gradually shrinking the balance sheet, reducing long-term asset holdings, weakening the Federal Reserve's quasi-fiscal role; and at the same time, rebuilding the inflation analysis framework, reducing reliance on dot plots and excessive forward guidance, and emphasizing price stability credibility, data quality, productivity, and structural factors such as AI. What Kevin Warsh truly wants to do may not be a traditional "dove or hawk monetary policy", but a reconstruction of the Federal Reserve's operational framework: on one hand, shrinking the balance sheet, weakening the normalization of QE and quasi-fiscal functions, on the other hand, effectively supporting the real economy and productivity improvements through the intelligent use of interest rate tools when conditions allow. In other words, what he wants is not simply "flooding the market", as was done during the COVID-19 pandemic, but to bring the Federal Reserve back from a policy system over-dependent on the balance sheet for over a decade to a framework that is more based on credibility, price stability, and more emphasizes "monetary principles". This is why he repeatedly emphasized reforming communication mechanisms, redefining the inflation framework, reducing forward guidance, and describing large-scale asset holdings as arrangements more favorable to "Wall Street" than "Main Street". Warsh sees not just a simple cyclical fluctuation, but the end of the old low inflation world after post-globalization, fragile supply chains, and normalized energy shocks. In this context, his criticism of the uncontrollable inflation in 2021-2022, his firm stance on the need to rewrite the "inflation framework", and his high regard for AI productivity dividends are all along the same line: he bets that future ways to lower inflation will no longer involve expanding the balance sheet to prop up assets and boost markets, but will rely on technological progress, productivity improvements, and a more restrained Federal Reserve balance sheet to rebuild monetary credibility. However, the problem lies in the fact that his latest suite of ideas has a consistency in direction, but there is still a strong uncertainty in execution - particularly in whether AI can generate deflationary productivity dividends fast enough, which is currently more of a strategic hypothesis than a validated growth reality. This also explains why Wall Street macroeconomists and strategists are sharply divided in their latest comments on Warsh: on the one hand, the mid-term view leans towards being "very creative and uniquely thoughtful," but short-term trading tends to be "difficult to materialize." On one hand, pathways for a "narrower balance sheet technical route" have already started to emerge, including loosening some liquidity regulations, reducing the banking system's demand for reserves, and adjusting interest rate control tools to create more space for lower short-term rates; from this perspective, Warsh's advocacy of "balance sheet reduction + rate cuts" is not contradictory in theory. On the other hand, the reality constraints are very hard: oil price shocks have pushed overall U.S. inflation to near two-year highs, core inflation had already surpassed the target by about 1 percentage point before the war with Iran, the University of Michigan survey shows inflation expectations for the next year surged to 4.8% this month, and market futures pricing shows the probability of any rate cuts this year is less than 50%. This means that even if Warsh takes office, it will be difficult for him to meet both Trump's political demand for an "immediate rate cut" and his own standard of price stability, where no one talks about inflation. Warsh's latest policy framework highlights that he may not be the "rate-cutting chairman" that Trump has long awaited, but rather someone who is trying to use a tighter liquidity framework to obtain greater policy flexibility in the future, a "restructuring reformist". His core monetary policy ambition is not to make the Federal Reserve balance sheet looser, but to transform the Federal Reserve from an "asset balance sheet-dominant central bank" into a "credibility and rule-dominant central bank"; rate cuts are just a possible outcome in this new framework, not the starting point. For the financial markets, this means that if Warsh ultimately pushes for reform, the first things to be significantly repriced will be the long-standing assumption of abundant U.S. dollar liquidity, followed by the interest rate path itself. And this is why the market's most realistic pricing attitude currently is not to believe that he will immediately bring about significant easing, but to judge that he may really want to "conduct a major reform of the Federal Reserve," but transforming this grand vision into an executable policy reality within the Federal Reserve FOMC, market acceptance, and political survivability will be extremely challenging.