Kevin Warsh Can Tame Inflation Without Higher Rates

The standard assessment of what faces Kevin Warsh as the new head of the Federal Reserve includes skepticism over whether he can accomplish the reforms he deems necessary as well as sympathy for him given the pressure from President Trump to lower interest rates.

The irony is that these objectives can be achieved in tandem, to the benefit of the private sector. Reforms under Mr. Warsh that reduce the Fed’s outsize presence in financial markets and reinforce free-market price signals will help wean monetary-policy makers off seeking to manage economic performance through artificially induced interest rates. One result of the central bank’s allowing market forces to determine the cost of capital would be that the Fed has to give up its predilection for imposing restrictive interest rates to squelch inflationary pressures—curtailing demand by suppressing economic growth. In this way, pro-market reform would mean over time interest rates lower than they otherwise would be.

Mr. Warsh’s appreciation for supply-side policies under Mr. Trump that have strengthened the economy will make him reluctant to work at cross-purposes with an agenda that is delivering private-sector gains. By reforming how the Fed models the effect of its interest-rate decisions on the economy, discarding Keynesian theories that bristle at low unemployment and high growth, Mr. Warsh can align monetary policy with the Trump administration’s goal of higher economic output to increase prosperity and to reduce inflationary pressures.

That doesn’t mean Mr. Warsh is anyone’s puppet. The chairman should make the case that expanding supply provides a better answer to inflation than constricting demand. Lower interest rates than the Fed would have imposed in knee-jerk restrictive mode aren’t a concession to Mr. Trump but the result of reducing the Fed’s distorting influence so that interactions in credit markets—where savers provide funds to borrowers—determine real interest rates.

The challenge for Mr. Warsh is to mesh the Fed’s two chief policy instruments into an effective approach to setting monetary policy. Reducing the central bank’s $6.7 trillion balance sheet through sales of government-backed bonds will put upward pressure on interest rates. To counter this effect, the Fed needs to lower the interest rate it pays to commercial banks on the cash reserve balances they hold at the central bank.

Paying interest on reserves began largely in response to the 2008 financial crisis and then Covid. Currently, banks receive 3.65% interest from the Fed on their $3.1 trillion in reserve balances—a hefty rate for what amounts to a riskless government-guaranteed overnight investment. If the Fed paid banks a lower rate on cash reserves, they would be drawn toward investing in likewise government-guaranteed Treasury securities. The increased demand would raise the price and reduce the yields on Treasurys, resulting in lower interest rates across the board.

The art of wielding this two-edged sword lies in simultaneously cutting the Fed’s balance sheet in accordance with Mr. Warsh’s longstanding recommendation while also slicing the Fed’s policy target interest rate, that is, the federal-funds rate, so that borrowers gain increased access to capital.

The latter action will facilitate the former. As banks reduce their cash reserves in response to the lower rate paid by the Fed on reserve balances, the central bank will find it easier to sell off a significant portion of its portfolio holdings into the enhanced market for government-backed financial assets.

Operationally, the Fed will end up in better shape with fewer liabilities. Even more important, the process of transforming the role of the nation’s central bank away from a government-knows-best approach to one that conforms more closely to free-market principles will have been launched. And a monetary policy consistent with the Trump administration’s pro-growth initiatives and based on a supply-side model of how the economy responds to the Fed’s interest-rate decisions will have been implemented.

If Mr. Trump is pleased with the results, it isn’t an indictment of Mr. Warsh. Coincidence is not causation. Mr. Warsh can point out, as his legendary predecessor Paul Volcker did under President Reagan, that strong economic growth and increased productivity are needed to help counter Congress’s deficit spending, which threatens long-run U.S. fiscal sustainability and monetary soundness. Mr. Volcker forcefully called for bringing the federal budget into balance as soon as possible, noting at the same time: “That objective cannot be achieved in a sluggish economy.”

Mr. Warsh can echo those sentiments before Congress and argue further that increased access to capital as the result of lower borrowing costs, in combination with reduced taxes and lower regulation, supports consumer resilience and solid labor markets. In contrast, monetary policy that accommodates fiscal profligacy through continual purchases of Treasury debt serves to enlarge government at the expense of the private sector.

The Fed’s monetary policy committee shouldn’t aim to hinder economic activity through its interest-rate decisions, but to release capital into the real economy to fund growth that expands opportunity, promotes innovation and raises living standards. If he persuades his fellow committee members to embrace that objective, Mr. Warsh will have the makings of a legendary central banker in his own right.