MICHAEL AVERY: Can Warsh end the Fed put?

Donald Trump’s choice of Jay Powell’s replacement signals one of the most dramatic turning points in modern market history.

In 1987 The Bangles’ Walk Like an Egyptian topped the charts while markets danced along with it. The Dow surged 44% in just seven months. Talk of bubbles was brushed aside as retail investors piled in and the party gathered pace.

Then the music stopped. By mid-October bad news began to cascade. A ballooning US trade deficit, weakening dollar, volatility creeping higher. Selling started on October 14 and intensified into the end of the week.

The pressure cooker blew on October 16, a chaotic “triple witching” session when options and futures expired together. By Friday’s close the Dow was already down 4.6%. During the weekend, US treasury secretary James Baker floated the idea of deliberately weakening the dollar to fix the trade gap, rattling nerves even further.

Before Wall Street had even opened on Monday, panic had swept through Asia. New Zealand’s market collapsed 60%. When US trading began, the Dow went into freefall, plunging 22.6% in a single day. The JSE all share index shed nearly 12%. One executive said it felt like someone shouting “Fire!” in a packed theatre.

The next morning Fed chair Alan Greenspan stepped in with a single sentence, stating that “the Federal Reserve, consistent with its responsibilities as the nation’s central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system”.

And with that the Fed put was born. Nearly four decades later, and this belief that the Fed will always backstop financial markets came to a shuddering halt with Trump’s nomination of Kevin Warsh as Fed chair.

While the Fed put is not an official policy — rather an expectation that the Fed will act as a “buyer of last resort” or cut rates to boost market sentiment — it has historically provided this, famously during the 2008 financial crisis and most recently in 2020 through the Covid-19 pandemic.

Warsh is accomplished, well-known and respected. He started his career on Wall Street after graduating from Harvard Law School, joined George W Bush’s National Economic Council, and served as a Fed governor in 2006-11. Warsh was a crucial link between the Fed and financial market leaders during the global financial crisis (GFC).

Notably, treasury secretary Scott Bessent and Warsh are protégés of Stanley Druckenmiller, the man who many on Wall Street simply refer to as “Druck”, as Financial Times’ Amelia Pollard noted in a fantastic profile of the hedge fund manager last year.

Warsh’s nomination has been welcomed by none other than Richard Clarida, MD of Pimco’s New York office and former vice-chair of the board of governors of the US Federal Reserve System from September 2018 to January 2022.

In a statement published on Pimco’s website on Friday, Clarida said Pimco believes Warsh will be confirmed by the Senate “and serve as an effective, thoughtful Fed chair”.

Clarida added that he’s “confident in the outlook for Fed independence, which appears to have broad support not just in markets but in Congress as well”.

Warsh’s more in-depth criticism is that the Fed has evolved into a de facto industrial and fiscal policymaker, inflating asset values, distorting price signals and favouring Wall Street over Main Street through frequent, arbitrary interventions.

It’s hard to argue against that. But Warsh will find himself on the horns of an intriguing dilemma if he tries to remove liquidity from a market that has — let’s be frank — become addicted to it with all the cruel intensity of a fentanyl addict.

Despite what Trump has said about Main St, the stock market has been his preferred measure of success. If it craters, will Warsh have the stomach to let it slide? Equally, this is terrible news for the crypto crowd, key supporters of Trump as his Trump and Melania coins are down almost 98%.

Warsh also favours a stronger dollar, pitting him against Stephen Miran and the so-called Mar-a-Lago Accord, which sought to weaken the dollar to boost US manufacturing.

Another interesting element to all this is Warsh’s belief in a so-called Fed-Treasury pact. One thing is certain — the mid-century Keynesian orthodoxy that has controlled central banking for almost a century is being upended by Trump’s self-proclaimed “Republican New Deal”. It casts doubt on the notion that technocrats at the Fed can adjust demand and save the economy each time asset prices fluctuate, and instead places production, labour and national capacity at the centre of economic policy.

It actually harks back to the mid-18th century if you were listening to US trade representative Jamieson Greer at Davos recently, invoking a new Hamiltonian age.

Alexander Hamilton was one of the founding fathers of the US and its first treasury secretary in the late 1700s. In a 1791 report to Congress he argued that the US should protect and build its own industries, especially manufacturing, instead of letting foreign goods dominate the domestic market.

Real rates may increase and emerging market financial conditions may tighten if investors think the Fed will overcorrect to demonstrate independence.

His plan included tariffs (taxes on imports) to protect fledgling US industries, as well as state support for strategic economic development and building a strong industrial base as part of a broader economic strategy.

Given that we know Trump’s Hamilton frame is to “use tariffs to rebuild industry”, the Warsh question becomes whether it’s possible to implement a tariff-heavy, industrial-policy-heavy agenda without rekindling inflation and making the Fed appear complicit.

Particularly if they are widespread tariffs that may cause inflation, or at the very least change the level of prices. Inflation expectations may un-anchor if investors think the Fed would be under pressure to cut nonetheless.

Real rates may increase and emerging market financial conditions may tighten if investors think the Fed will overcorrect to demonstrate independence. Depending on the pace and politics, markets may interpret Warsh’s goal in reducing the Fed’s influence (balance sheet, mandate creep) as either destabilising or restoring credibility.

And perhaps the most jarring change under a Warsh Fed won’t be in rates, but in rhetoric. The era of heavy-handed forward guidance may be coming to an end. Warsh has long argued that the Fed can deliver stability without constantly telegraphing its next move, pointing to the Paul Volcker and early Greenspan years as proof.

But markets have grown addicted to central bank reassurance. Weaning investors off the Fed’s soothing words may prove just as volatile as withdrawing its liquidity.

• Avery, a financial journalist and broadcaster, produces BDTV’s ‘Business Watch’. Contact him at michael@fmr.co.za.