Will the Federal Reserve also have to consider Congress's opinion? The new Warsh policy may face a "lame duck" crisis.
2026-05-07 18:40:44
In addition to addressing liquidity issues, the Federal Reserve also needs to consider new risks brought about by the midterm elections as it continues its path of interest rate cuts.
Regarding liquidity, the Federal Reserve is caught in a complex dilemma of precise control: on the one hand, it needs to maintain an ample reserve base to avoid triggering a disorderly surge in overnight lending rates due to a liquidity gap—the lesson of the "cash crunch" in September 2019 is still fresh in our minds, when the scarcity of reserves led to a runaway short-term interest rate, forcing the Federal Reserve to urgently restart repurchase operations to save the market.
On the other hand, excessively high excess reserves will increase the pressure on the central bank's balance sheet management, and it is urgent to promote balance sheet reduction without disturbing the interest rate center.
If the midterm elections result in a major upset, the deteriorating US fiscal situation will further complicate policy matters.
The Federal Reserve's current interest rate control system is built on a framework of ample reserves, the core logic of which is to stabilize market interest rate expectations through a sufficient supply of reserves.
However, data from the end of 2025 showed that the size of reserves had approached a critical threshold, and the pressure on overnight interest rates to rise was beginning to emerge. This directly prompted the Federal Reserve to terminate the quantitative tightening cycle and restart balance sheet expansion to alleviate liquidity risks.
Although Federal Reserve researchers have outlined alternative paths for balance sheet reduction—the core of which is to reduce the need for commercial banks to allocate precautionary reserves by revising macroprudential liquidity regulatory rules, thereby achieving a balance sheet reduction target of $1.2 trillion to $2.1 trillion—this calculation is subject to extremely high uncertainty.
Fitch Ratings explicitly points out that quantitative tightening is highly likely to trigger unexpected interest rate fluctuations, and large-scale quantitative tightening in the short term is not feasible. The Fed's quantitative tightening process will be constrained by the physical constraints of interest rate fluctuations and can only be carried out in a gradual manner.
Financial markets widely expect that Trump's nominee, Kevin Warsh, will be confirmed by the Senate and take over the Federal Reserve amid a backdrop of weakening economic growth and rising inflationary pressures.
Warsh's proposals at the Senate hearing, such as "the Fed needs a radical overhaul" and "encouraging vigorous internal debate," stand in stark contrast to the Fed's long-standing principles of decision-making discipline and consensus-oriented approach, and may further exacerbate market concerns about policy uncertainty.
Credibility fractures: Impaired independence hinders policy transmission
Ron Temple, chief market strategist at asset management giant Lazard Group, is cautious about Walsh's policy maneuvering.
He pointed out that the continued blows to the Federal Reserve's independence over the past few years—including the Trump administration's year-long pressure to cut interest rates and the Justice Department's criminal investigation of Powell—have caused irreparable and permanent damage to the institution's reputation.
Temple emphasized that "market perception is equivalent to objective reality when it comes to the credibility of central banks. Even if Warsh officially takes office, investors' distrust of the Federal Open Market Committee's (FOMC) decision-making motives will continue, which will significantly limit the effectiveness of its policy transmission."
External constraints: the dual pressure of institutional limitations and fiscal constraints
Walsh's policy influence is also constrained by the system: he has only one vote in the FOMC and cannot unilaterally influence policy outcomes, which to some extent limits the risk of policy abrupt changes.
The deteriorating fiscal situation in the United States has further complicated policy matters. Temple predicts that the Democrats will likely control the House of Representatives after the midterm elections in November, and the recovery of spending in areas such as Medicaid will drive additional fiscal spending to exceed one trillion dollars over the next eight years. Coupled with the costs of the war with Iran and the replenishment of military equipment, the annual deficit rate of the United States will remain in the range of 6.5% to 8.0% over the next ten years, and the debt ratio will climb to 140% by 2036.
This fiscal expansion, coupled with the growing rift in confidence regarding the Federal Reserve's independence, will force investors to demand higher term premiums for long-term bonds, further limiting Warsh's policy maneuvering space.
As discussed in previous articles about the Federal Reserve, Warsh proposed a combination of quantitative tightening and interest rate cuts. Quantitative tightening would continuously absorb market liquidity to curb inflation, while interest rate cuts would stimulate economic activity. Simultaneously, he would shift the focus from tracking the traditionally rising PCE data to other inflation indicators such as the declining cut-off mean inflation, maintaining the Fed's consistent data-driven approach. Finally, he aimed to reduce the Fed's public exposure, increase its independence, and minimize its direct impact on the market.
As this article shows, this strategy requires the White House to secure a sufficient number of congressional seats; otherwise, if the Democrats gain control of Congress, the interest rate cuts may not be implemented as scheduled.
Given the recent string of positive developments from the US and Iran, it's easy to deduce that the White House desperately needs this midterm election; otherwise, both the new Federal Reserve Chairman and the US President risk becoming a lame-duck president.
However, with the midterm elections scheduled to begin in late May, the market has slightly increased its expectations for a Fed rate cut this year, influenced by Warsh's impending appointment as Fed chairman and the dovish comments from Williams, the Fed's third-ranking official.
Regarding liquidity, the Federal Reserve is caught in a complex dilemma of precise control: on the one hand, it needs to maintain an ample reserve base to avoid triggering a disorderly surge in overnight lending rates due to a liquidity gap—the lesson of the "cash crunch" in September 2019 is still fresh in our minds, when the scarcity of reserves led to a runaway short-term interest rate, forcing the Federal Reserve to urgently restart repurchase operations to save the market.
On the other hand, excessively high excess reserves will increase the pressure on the central bank's balance sheet management, and it is urgent to promote balance sheet reduction without disturbing the interest rate center.
If the midterm elections result in a major upset, the deteriorating US fiscal situation will further complicate policy matters.
Framework constraints: The double-edged sword effect of an ample reserve system
The Federal Reserve's current interest rate control system is built on a framework of ample reserves, the core logic of which is to stabilize market interest rate expectations through a sufficient supply of reserves.
However, data from the end of 2025 showed that the size of reserves had approached a critical threshold, and the pressure on overnight interest rates to rise was beginning to emerge. This directly prompted the Federal Reserve to terminate the quantitative tightening cycle and restart balance sheet expansion to alleviate liquidity risks.
Reduction of the table: Alternative solutions and obstacles to implementation
Although Federal Reserve researchers have outlined alternative paths for balance sheet reduction—the core of which is to reduce the need for commercial banks to allocate precautionary reserves by revising macroprudential liquidity regulatory rules, thereby achieving a balance sheet reduction target of $1.2 trillion to $2.1 trillion—this calculation is subject to extremely high uncertainty.
Fitch Ratings explicitly points out that quantitative tightening is highly likely to trigger unexpected interest rate fluctuations, and large-scale quantitative tightening in the short term is not feasible. The Fed's quantitative tightening process will be constrained by the physical constraints of interest rate fluctuations and can only be carried out in a gradual manner.
Institutional Perspective: Warsh's Policy Scope and Challenges
Financial markets widely expect that Trump's nominee, Kevin Warsh, will be confirmed by the Senate and take over the Federal Reserve amid a backdrop of weakening economic growth and rising inflationary pressures.
Warsh's proposals at the Senate hearing, such as "the Fed needs a radical overhaul" and "encouraging vigorous internal debate," stand in stark contrast to the Fed's long-standing principles of decision-making discipline and consensus-oriented approach, and may further exacerbate market concerns about policy uncertainty.
Credibility fractures: Impaired independence hinders policy transmission
Ron Temple, chief market strategist at asset management giant Lazard Group, is cautious about Walsh's policy maneuvering.
He pointed out that the continued blows to the Federal Reserve's independence over the past few years—including the Trump administration's year-long pressure to cut interest rates and the Justice Department's criminal investigation of Powell—have caused irreparable and permanent damage to the institution's reputation.
Temple emphasized that "market perception is equivalent to objective reality when it comes to the credibility of central banks. Even if Warsh officially takes office, investors' distrust of the Federal Open Market Committee's (FOMC) decision-making motives will continue, which will significantly limit the effectiveness of its policy transmission."
External constraints: the dual pressure of institutional limitations and fiscal constraints
Walsh's policy influence is also constrained by the system: he has only one vote in the FOMC and cannot unilaterally influence policy outcomes, which to some extent limits the risk of policy abrupt changes.
The deteriorating fiscal situation in the United States has further complicated policy matters. Temple predicts that the Democrats will likely control the House of Representatives after the midterm elections in November, and the recovery of spending in areas such as Medicaid will drive additional fiscal spending to exceed one trillion dollars over the next eight years. Coupled with the costs of the war with Iran and the replenishment of military equipment, the annual deficit rate of the United States will remain in the range of 6.5% to 8.0% over the next ten years, and the debt ratio will climb to 140% by 2036.
This fiscal expansion, coupled with the growing rift in confidence regarding the Federal Reserve's independence, will force investors to demand higher term premiums for long-term bonds, further limiting Warsh's policy maneuvering space.
Summarize:
As discussed in previous articles about the Federal Reserve, Warsh proposed a combination of quantitative tightening and interest rate cuts. Quantitative tightening would continuously absorb market liquidity to curb inflation, while interest rate cuts would stimulate economic activity. Simultaneously, he would shift the focus from tracking the traditionally rising PCE data to other inflation indicators such as the declining cut-off mean inflation, maintaining the Fed's consistent data-driven approach. Finally, he aimed to reduce the Fed's public exposure, increase its independence, and minimize its direct impact on the market.
As this article shows, this strategy requires the White House to secure a sufficient number of congressional seats; otherwise, if the Democrats gain control of Congress, the interest rate cuts may not be implemented as scheduled.
Given the recent string of positive developments from the US and Iran, it's easy to deduce that the White House desperately needs this midterm election; otherwise, both the new Federal Reserve Chairman and the US President risk becoming a lame-duck president.
However, with the midterm elections scheduled to begin in late May, the market has slightly increased its expectations for a Fed rate cut this year, influenced by Warsh's impending appointment as Fed chairman and the dovish comments from Williams, the Fed's third-ranking official.
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