Federal Reserve Independence Under Renewed Threat: Warsh Agreement May Reshape Fed Balance Sheet, Swap Limits Become Key Test
2026-05-05 11:02:56
Most people don't understand what a currency swap line is, nor do they have much reason to care about this financial instrument. But soon, this tool may help the market truly understand what Kevin Warsh, the nominee for Federal Reserve Chairman, really means regarding the Fed's unique philosophy on independence.
Warsh made it clear that the Federal Reserve should remain "strictly independent" in setting monetary policy. However, he added that he was willing to cooperate with Congress and the Trump administration on "non-monetary matters."
In response to written questions from senators after confirming his hearing on April 21, Warsh further elaborated: "In areas such as international finance, Federal Reserve officials should not enjoy the same special respect as in other areas."
Warsh also repeatedly mentioned a new "Federal Reserve-Treasury Agreement," which he believes could be used to manage the Federal Reserve's balance sheet, though he has not yet elaborated on the specifics.
Six former Federal Reserve officials said Warsh's statements were at least unclear, even confusing. In the worst-case scenario, they expressed concern about Warsh's analysis of the Fed's independence. The result could be merely marginal adjustments to existing practices, or it could impose more serious limitations on the Fed's ability to use its balance sheet during a crisis. Due to the lack of clarity in Warsh's statements, these former officials are currently unwilling to draw definitive conclusions.
Former Richmond Fed President Jeffrey Lacker, a long-time hawk on interest rates and balance sheet policy, said he would welcome a new agreement that would allow the Fed to focus on monetary policy while leaving credit policy to the Treasury. For example, under such an agreement, the Fed might only be allowed to buy Treasury bonds, but not mortgage-backed securities or other financial instruments.
But Lacker added, "I can also imagine a less constructive agreement that would allow the Treasury to use the Fed's balance sheet to bypass Congress, perpetuate bad practices, and undermine the Fed's independence."
A senior former Federal Reserve official, who declined to be named, bluntly stated: "If we follow the logic to the end, the Federal Reserve may lose control of its balance sheet."
Warsh's definition of monetary policy and non-monetary policy remains unclear. He may elaborate further after Senate confirmation, but for now, lawyers, economists, and Fed watchers can only scrutinize the vague wording in his Senate response.
Walsh declined to comment on the article.
Several former Federal Reserve officials have pointed out that currency swap lines exist in a gray area between monetary and non-monetary policies. This tool was primarily used during the financial crisis, where the Federal Reserve provided dollars to other central banks in exchange for an equivalent amount of their currency. Fed officials believe that such arrangements aim to provide dollar liquidity to foreign markets and prevent a surge in foreign dollar purchases from impacting the US market.
Treasury Secretary Scott Bessent recently stated that several Gulf states, including the United Arab Emirates, have requested currency swap lines. The Treasury could provide such lines using its own funds, as it recently did with Argentina, but it remains unclear whether Bessent would prefer the Federal Reserve to provide them. In a written question, a senator asked Warsh whether he believed the Federal Reserve must yield to the Treasury's wishes, but Warsh did not answer directly.
Former Federal Reserve officials believe that currency swap lines fall at least partly within the scope of monetary policy. First, such arrangements must be approved by the Federal Open Market Committee (FOMC), the body responsible for setting monetary policy. Second, when swap lines are used, providing dollars to foreign central banks expands the Fed's balance sheet. According to Haver Analytics data, during the 2008 global financial crisis, swap lines briefly increased the Fed's balance sheet by nearly $600 billion, approximately 25% of its then-current size. During the COVID-19 pandemic, swap lines peaked at $450 billion.
Warsh's remarks are unlikely to change policy immediately. In times of crisis, the Federal Reserve and the Treasury typically cooperate to address market turmoil, as demonstrated during Warsh's tenure as a Fed governor in the 2007-2008 crisis. However, the final decision rests with the Fed, and the justification is almost always a systemic and significant disruption to dollar liquidity.
Another former Federal Reserve official, who declined to be named, warned: "In the worst-case scenario, the Fed's balance sheet could become a tool for foreign aid."
The risk is particularly concerning regarding providing swap lines to Gulf states like the UAE. These countries currently do not appear to need swap lines to mitigate a dollar liquidity crisis, so providing such support may be more of a political decision than a judgment based on actual market demand. Even if the Gulf states experience liquidity problems, there is currently no significant dollar funding pressure within the US. The UAE, as a wealthy nation, possesses substantial foreign exchange reserves and a sovereign wealth fund. Furthermore, the US government has ample reason to assist its allies in the conflict with Iran. Several officials have pointed out that dollar swap lines would grant the UAE international prestige typically reserved for major developed countries like the G7.
Warsh's proposed changes could impact a wider area of the Federal Reserve's operations. His envisioned revised "Treasury-Federal Reserve Agreement" would manage the size and potential composition of the Fed's balance sheet in some way that is not yet clearly defined. This suggests that Warsh, unlike other Fed officials, does not view balance sheet policy as an integral part of monetary policy.
Both Warsh and Bessant have criticized the Federal Reserve for excessively expanding its balance sheet during non-crisis periods. In fact, Warsh resigned as a governor in 2011 precisely because he opposed the Fed's failure to shrink its balance sheet after the Great Recession.
Bessant likened the Federal Reserve’s ever-expanding balance sheet to a dangerous laboratory experiment, arguing that it expands the Fed’s footprint in the economy and gives it powers that should belong to the Treasury and the government.
Former Boston Fed President Eric Rosengren pointed out that if the Fed agrees to limit the size and composition of its balance sheet and requires permission from the Treasury Department to act, then the flexibility of monetary policy in a severe crisis will be severely constrained.
Several former officials worry that if the Treasury Department could direct the Federal Reserve to purchase a specific amount or type of asset, the Fed's independence would be further compromised, potentially triggering unease in the bond market.
Former St. Louis Fed President Jim Bullard said the idea of Fed-Treasury cooperation to limit the Fed’s asset purchases had been discussed for some time, but he had reservations about the “close cooperation” reflected in some of Bessant’s statements.
Despite the aforementioned controversies, Warsh may have believed that by voluntarily relinquishing other responsibilities, he could ensure the Federal Reserve's core function of setting interest rates remained independent, an independence that even the president who nominated him could not question. He hinted at this view during his nomination hearings: "Presidents want lower interest rates, but the Fed's independence is in the Fed's own hands."
Overall , Kevin Warsh's nomination and his ideas are bringing issues such as Federal Reserve independence, balance sheet management, and international financial instruments to the forefront. The final outcome will depend on the Senate confirmation process, Warsh's subsequent elaboration, and actual policy direction. This discussion not only concerns the future operation of the Federal Reserve but will also profoundly impact the global financial stability landscape, warranting continued attention.
Warsh made it clear that the Federal Reserve should remain "strictly independent" in setting monetary policy. However, he added that he was willing to cooperate with Congress and the Trump administration on "non-monetary matters."
In response to written questions from senators after confirming his hearing on April 21, Warsh further elaborated: "In areas such as international finance, Federal Reserve officials should not enjoy the same special respect as in other areas."
Warsh also repeatedly mentioned a new "Federal Reserve-Treasury Agreement," which he believes could be used to manage the Federal Reserve's balance sheet, though he has not yet elaborated on the specifics.
Former Federal Reserve official expresses concerns: Independence faces potential risks
Six former Federal Reserve officials said Warsh's statements were at least unclear, even confusing. In the worst-case scenario, they expressed concern about Warsh's analysis of the Fed's independence. The result could be merely marginal adjustments to existing practices, or it could impose more serious limitations on the Fed's ability to use its balance sheet during a crisis. Due to the lack of clarity in Warsh's statements, these former officials are currently unwilling to draw definitive conclusions.
Former Richmond Fed President Jeffrey Lacker, a long-time hawk on interest rates and balance sheet policy, said he would welcome a new agreement that would allow the Fed to focus on monetary policy while leaving credit policy to the Treasury. For example, under such an agreement, the Fed might only be allowed to buy Treasury bonds, but not mortgage-backed securities or other financial instruments.
But Lacker added, "I can also imagine a less constructive agreement that would allow the Treasury to use the Fed's balance sheet to bypass Congress, perpetuate bad practices, and undermine the Fed's independence."
A senior former Federal Reserve official, who declined to be named, bluntly stated: "If we follow the logic to the end, the Federal Reserve may lose control of its balance sheet."
The gray area of currency swap lines
Warsh's definition of monetary policy and non-monetary policy remains unclear. He may elaborate further after Senate confirmation, but for now, lawyers, economists, and Fed watchers can only scrutinize the vague wording in his Senate response.
Walsh declined to comment on the article.
Several former Federal Reserve officials have pointed out that currency swap lines exist in a gray area between monetary and non-monetary policies. This tool was primarily used during the financial crisis, where the Federal Reserve provided dollars to other central banks in exchange for an equivalent amount of their currency. Fed officials believe that such arrangements aim to provide dollar liquidity to foreign markets and prevent a surge in foreign dollar purchases from impacting the US market.
Treasury Secretary Scott Bessent recently stated that several Gulf states, including the United Arab Emirates, have requested currency swap lines. The Treasury could provide such lines using its own funds, as it recently did with Argentina, but it remains unclear whether Bessent would prefer the Federal Reserve to provide them. In a written question, a senator asked Warsh whether he believed the Federal Reserve must yield to the Treasury's wishes, but Warsh did not answer directly.
The practical role and potential risks during a crisis
Former Federal Reserve officials believe that currency swap lines fall at least partly within the scope of monetary policy. First, such arrangements must be approved by the Federal Open Market Committee (FOMC), the body responsible for setting monetary policy. Second, when swap lines are used, providing dollars to foreign central banks expands the Fed's balance sheet. According to Haver Analytics data, during the 2008 global financial crisis, swap lines briefly increased the Fed's balance sheet by nearly $600 billion, approximately 25% of its then-current size. During the COVID-19 pandemic, swap lines peaked at $450 billion.
Warsh's remarks are unlikely to change policy immediately. In times of crisis, the Federal Reserve and the Treasury typically cooperate to address market turmoil, as demonstrated during Warsh's tenure as a Fed governor in the 2007-2008 crisis. However, the final decision rests with the Fed, and the justification is almost always a systemic and significant disruption to dollar liquidity.
Another former Federal Reserve official, who declined to be named, warned: "In the worst-case scenario, the Fed's balance sheet could become a tool for foreign aid."
The risk is particularly concerning regarding providing swap lines to Gulf states like the UAE. These countries currently do not appear to need swap lines to mitigate a dollar liquidity crisis, so providing such support may be more of a political decision than a judgment based on actual market demand. Even if the Gulf states experience liquidity problems, there is currently no significant dollar funding pressure within the US. The UAE, as a wealthy nation, possesses substantial foreign exchange reserves and a sovereign wealth fund. Furthermore, the US government has ample reason to assist its allies in the conflict with Iran. Several officials have pointed out that dollar swap lines would grant the UAE international prestige typically reserved for major developed countries like the G7.
Balance sheet management becomes the core point of contention
Warsh's proposed changes could impact a wider area of the Federal Reserve's operations. His envisioned revised "Treasury-Federal Reserve Agreement" would manage the size and potential composition of the Fed's balance sheet in some way that is not yet clearly defined. This suggests that Warsh, unlike other Fed officials, does not view balance sheet policy as an integral part of monetary policy.
Both Warsh and Bessant have criticized the Federal Reserve for excessively expanding its balance sheet during non-crisis periods. In fact, Warsh resigned as a governor in 2011 precisely because he opposed the Fed's failure to shrink its balance sheet after the Great Recession.
Bessant likened the Federal Reserve’s ever-expanding balance sheet to a dangerous laboratory experiment, arguing that it expands the Fed’s footprint in the economy and gives it powers that should belong to the Treasury and the government.
Former Boston Fed President Eric Rosengren pointed out that if the Fed agrees to limit the size and composition of its balance sheet and requires permission from the Treasury Department to act, then the flexibility of monetary policy in a severe crisis will be severely constrained.
The future trend remains to be seen.
Several former officials worry that if the Treasury Department could direct the Federal Reserve to purchase a specific amount or type of asset, the Fed's independence would be further compromised, potentially triggering unease in the bond market.
Former St. Louis Fed President Jim Bullard said the idea of Fed-Treasury cooperation to limit the Fed’s asset purchases had been discussed for some time, but he had reservations about the “close cooperation” reflected in some of Bessant’s statements.
Despite the aforementioned controversies, Warsh may have believed that by voluntarily relinquishing other responsibilities, he could ensure the Federal Reserve's core function of setting interest rates remained independent, an independence that even the president who nominated him could not question. He hinted at this view during his nomination hearings: "Presidents want lower interest rates, but the Fed's independence is in the Fed's own hands."
Overall , Kevin Warsh's nomination and his ideas are bringing issues such as Federal Reserve independence, balance sheet management, and international financial instruments to the forefront. The final outcome will depend on the Senate confirmation process, Warsh's subsequent elaboration, and actual policy direction. This discussion not only concerns the future operation of the Federal Reserve but will also profoundly impact the global financial stability landscape, warranting continued attention.
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