Kevin Warsh's Fed will navigate a radically new era

If confirmed, Kevin Warsh will take over the Federal Reserve at a time of radical new challenges for central bankers.

The global economy must accommodate seismic changes in international security and economic arrangements, as well as the technologies now driving growth.

Central bankers’ primary tasks remain unchanged: Keep inflation in check at about 2% and support robust labor markets.

U.S. unemployment at 4.3% is reasonably low, but one-quarter of the jobless have been seeking positions for more than six months.

White-collar workers displaced by artificial intelligence from banks and other service establishments face cruel choices.

Many won’t again find the kinds of good-paying jobs they only recently enjoyed and must accept lower pay or retrain, often for blue-collar work.

The economy has more college graduates with general degrees in business, the social sciences and the humanities than it can absorb.

The last two times the economy faced such challenges, the global financial crisis of 2007-2009 and COVID-19, Western governments responded with excessive borrowing to support financial institutions and households.

Central banks purchased considerable portions of this debt and expanded their balance sheets, so-called quantitative easing.

Mr. Warsh and others characterize this as an excessive increase in the Fed’s footprint in the economy and something that needs to be reversed.

Perhaps not repeated, but those episodes can’t be reversed.

In the current environment, Fed policy would be neutral if it just stood pat.

Since peaking at $8.9 trillion in April 2022, it has worked down its balance sheet to $6.6 trillion.

Just before the global financial crisis, the federal budget was nearly balanced. In 2007, the deficit was 1.2% of gross domestic product. By the end of Barack Obama’s presidency, new federal initiatives, such as the Affordable Care Act, brought the federal deficit to 2.9% of GDP.

The Fed’s balance sheet expanded significantly to bail out banks and households during the global financial crisis, but it didn’t permanently enlarge federal deficits.

In the latter half of the 2010s, the Fed’s balance sheet remained flat at about $4 trillion before shrinking.

Domestic and international bond investors, not the Fed, financed permanently larger annual federal deficits by running the printing press.

President Trump’s first-term tax cuts and President Biden’s industrial policies further increased the federal deficit to about 6%, depending on how much of the Trump tariffs the Supreme Court allows to stand.

Although the Fed initially enabled the Biden industrial policies by expanding its balance sheet, since it got serious about inflation, monetary policy hasn’t been loose.

Its balance sheet, which stood at $8.9 trillion in April 2022, is now $6.6 trillion.

That’s why, as the bank’s overnight borrowing or federal funds rate has been lowered to 1.75%, the 10-year Treasury rate, which critically influences mortgage and business borrowing costs, has increased by about 0.4 percentage points.

If the Fed significantly reduced its balance sheet further, then the federal government would have to dramatically reduce its budget deficit. The Treasury would face more competition in international credit markets from other governments expanding their annual deficits, and the bonds the Fed would be selling.

The European Union is borrowing up to $1 trillion to rebuild its militaries to cope with receding U.S. security guarantees and Russia’s revanchist designs on Eastern Europe.

Japan’s new prime minister, Sanae Takaichi, is committed to altering Japan’s constitution to permit rearmament and new investments to stimulate civilian growth.

Britain is looking to partner with private capital to rearm.

American hyperscalers — Amazon, Alphabet, Microsoft and Meta — are committed to doubling capital spending from 2024 levels, largely for AI data centers and supporting infrastructure, to about 2% of GDP.

That’s a massive new stimulus program financed by just four private firms.

Their prodigious revenues alone cannot fund all this, and they are entering international capital markets by selling bonds on a scale comparable to that of midsize advanced-economy governments.

The bill is due on Social Security.

By 2032, the trust fund that finances old age pensions will be empty, and Congress must preside over a 24% reduction in benefits, substantial tax increases or further increased borrowing — something credit markets would likely balk at.

It’s not up to the Fed or any other central bank to solve any or all of this, but the Fed, by selling off a few trillion dollars from its balance sheet, would shatter global capital markets and send longer-term interest rates, such as the 10-year Treasury rate, rocketing.

Mr. Warsh can accede to Mr. Trump’s demands for lower interest rates by lowering the federal funds rate, but he can’t deliver a lower 10-year Treasury rate without running the printing press to buy longer-term government bonds.

Ruinous inflation would follow.

We are about to witness a massive reallocation of global savings to support rearming the West, the AI transformation and an aging population.

The Fed will be challenged to simply stand on the sidelines and let markets and politics do their work.

• Peter Morici is an economist and emeritus business professor at the University of Maryland, and a national columnist.