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Kevin Warsh has now been sworn in as the new Federal Reserve Chair. Outgoing Chair Jerome Powell has refused to leave the Fed Board of Governors, breaking with the modern custom that departing Fed chairs leave the Board rather than linger as rival power centers.
The clear danger: Powell will have enough Board support to act as Fed Shadow Chair and force a series of rate hikes down Warsh’s throat.
Never mind that even a single rate hike would be the worst possible response to an oil-price shock. Never mind that two of Jay Powell’s predecessors understood the difference between demand inflation and an oil shock.
When Iraq invaded Kuwait in 1990, Alan Greenspan understood that an oil shock can both raise headline inflation and damage growth. His FOMC repeatedly cut the federal-funds rate as the economy weakened.
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When oil, foodstuffs, fertilizers, and industrial metals all moved sharply higher in 2008 — driven by booming emerging-market demand, constrained supply, thin spare capacity, and speculative flows — Ben Bernanke’s Fed likewise cut the federal-funds rate in April. He then held steady in June and refused to launch a recessionary rate-hike campaign into prices the Fed could not drill, refine, mine, plant, or ship away.
That is the looming central error. The Fed cannot produce one extra barrel of oil. It cannot reopen a shipping lane. It cannot refine gasoline. It cannot lower diesel costs by crushing mortgage demand in Ohio or forcing a small manufacturer in Pennsylvania to roll over credit at punitive rates.
A Fed rate hike now would rein in demand in response to a supply shock and hit precisely where the economy is already vulnerable. Housing would weaken further. Interest-sensitive manufacturing would suffer. Small-business credit would tighten. Financial conditions would tighten just as energy prices are eating real incomes. The dollar could strengthen, pressuring exporters.
Memo to the Fed: An oil shock already acts like a tax increase. It takes money out of household budgets, raises transportation costs, compresses margins and slows real activity. If the Fed layers another rate hike on top of that, it does not solve the oil problem. It simply adds a credit shock to an energy shock.
Why do that when bond market vigilantes are already doing the contractionary policy work. A 30-year Treasury yield north of 5% and a ten-year north of 4.5% is not loose money. Mortgage rates, corporate borrowing costs and duration-sensitive assets are already feeling the heat. In that weather, the central bank does not need to prove its toughness or independence by firing another round into the hull of the ship.
Nor are the April inflation reports an argument for panic. Core PPI came in a bit hot at 4.4% but core CPI was 2.8%. Neither number justifies treating an energy-led commodity shock as a demand-side emergency.
The right question is whether the oil spike will spill into elements of the core and create second-round wage-price dynamics. We have a long way to go before we will know, and the Fed should not be in the business of playing worst case scenario games.
Instead, the Fed’s job is as it always should be, to keep inflation expectations anchored while preserving maximum employment. As long bond yields rise, risk shifts increasingly to the recession side — as Greenspan and Bernanke long ago understood.
That’s where the specter of Powell as Shadow Chair rears its ugly head: Three Biden-appointed governors — Philip Jefferson, Michael Barr, and Lisa Cook — remain in place. Powell and this Biden trio can now already form a four-vote majority on the seven-member Board. Bad enough.
If Trump appointee Christopher Waller proves to be the pivotal defector, as he is signaling, this would turn Powell’s Shadow Chair majority into a rout. Warsh would have the title. Powell would control the reaction function.
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And the regional Fed presidents in Cleveland, Minneapolis, and Dallas — Beth Hammack, Neel Kashkari, and Lorie Logan — are already forming the chorus line for a possible hawkish pivot.
It is by this Shadow Chair math that Kevin Warsh — and the American economy — may get boxed in. If Powell, his Biden-era allies, and the regional hawks force a rate-hike campaign into an oil shock, they will not be defending the Fed’s credibility or proving its independence. They will be adding a credit shock to an energy shock — and proving only recklessness. The bill will come due not in the Eccles Building, but in factories, homes, small businesses, and export markets across America.
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