Regulatory arbitrage

Revealed preference?

Now that President Trump has elevated market consideration of my previously-out-of-consensus pick for Fed chairman, Kevin Warsh, it’s worth following up on what his Administration’s ultimate objectives for the Fed are. The consensus view that it is all about lower rates and monetizing US debt never made much sense given (a) President Trump’s incentives and modus operandi, and (b) his Administration’s consistent criticism of the Fed’s excessively large balance sheet. The former led me to suspect a hawkish pivot by the President in 2026 – at least with respect to his appointees – and is consistent with former Fed Governor Warsh as a leading candidate. But Mr. Warsh also is the candidate most aligned with Fed reform. Despite its potential for more far-reaching effects than the Fed funds path alone, the prospect of Fed reform has gotten too little attention from markets.

Fed reform

There are several aspects of Fed reform that have been mentioned, repeatedly, by top Administration officials.¹1 First and foremost is to dramatically reduce the Fed’s balance sheet and imprint in markets. The second is to democratize the Fed to make it more accountable to and reflective of “Main Street’s” rather than Wall Street’s priorities. Third is to refocus it on its core mandates of price stability and lender of last resort, critically by shifting its regulatory duties to other agencies.

Alignment with consensus? Or voters?

The named Fed reform priorities do not well align with the consensus caricature of Trump Administration priorities. As I’ve previously noted, reducing the Fed’s balance sheet is directly at odds with popular assumptions that the Administration is intent on fiscal dominance. Similarly, increasing the power of regional Federal Reserve Bank presidents and requiring them to be from and representative of their respective districts flies in the face of White House control of the Fed.²2 And while orthodox central banking would help contain long-term Treasury yields, it wouldn’t “inflate away” the debt. Yet, Fed reform would align well with Trump supporters’ priorities to contain inflation, reduce government interference in markets, and boost growth of domestic small and medium enterprises by encouraging bank lending.

The road from serfdom

The road to all these priorities lies through deregulation, and the Fed is the critical institution to effect that deregulation. That likely better explains the Administration’s focus on control of the Federal Reserve Board than the President’s rhetorical justification for lower rates. I’ve noted many times that in pursuit of his objectives, President Trump is extremely talented at misdirection that either deflects opposition or aligns with voters’ preconceptions. Financial deregulation – a demonstrated Administration priority³3 – is as complex as the regulation it is meant to simplify and easily misunderstood. Hence it is much easier to sell lower interest rates, which have straightforward benefits for voters but require opponents to explain why “Modern Monetary Theory” is the equivalent of macroeconomic witchcraft.

…Goes through the Fed

Amazingly, the Administration can achieve most of the financial deregulation it seeks – and roll back the Fed’s post-crisis overreach – without asking Congress to amend a single statute. Neither the Bank Holding Company Act, nor the Federal Reserve Act, nor Dodd-Frank needs to be rewritten to materially loosen the constraints that have throttled bank balance sheets and credit creation. The reason is simple: while Congress defines the parameters – the Basel III international regulatory framework – it delegated extraordinary discretion to the Fed. The Federal Reserve Board, working in concert with the Office of the Comptroller of the Currency and the FDIC – both already under Administration control – determines how binding capital, leverage, liquidity, and stress-testing rules are in practice, while the Federal Reserve District Banks implement interpretation and enforcement of those rules.

Freeing banks from Basel’s ratios

Thus, the Fed cannot repeal Basel III, but it can recalibrate its regulatory ratios into irrelevance. The leverage ratio, the stress capital buffer, liquidity coverage assumptions, and stable funding requirements are all defined, modeled, phased, and enforced by regulators, not legislators. It is Basel III’s internally contradictory ratios that have enforced “regulatory dominance” of banks and boxed the Fed into maintaining a permanently bloated balance sheet to prevent plumbing failures of its own making.⁴4 Redefining those constraints – particularly leverage and liquidity treatment of Treasuries and reserves – would free balance-sheet capacity immediately, encouraging bank lending to domestic small and medium enterprises (SMEs) while allowing a return to “scarce-reserve” monetary policy without destabilizing markets.

Bringing along the Reserve Banks

The remaining friction is institutional rather than legal and explains why the Administration is focused on the Reserve Banks’ presidents. While the Board of Governors sets regulation and supervises enforcement, the Federal Reserve District Banks implement those rules and set the regulatory tone with banks. That is particularly important for regional commercial banks that are responsible for much of the lending to SMEs. But the New York Fed, which manages the System Open Market Account (SOMA), also plays an outsized role in monetary policy operations. The SOMA portfolio not only represents the lion’s share of the Fed’s balance sheet, hence is critical to reducing its size and imprint in markets, but is the conduit via which the Fed would return to the pre-2008 “corridor system” of Fed funds rate management after 17 years operating a “floor system” of excess reserves. Thus, aligning the regional Bank presidents is a necessary complement to Board control if regulatory relief is to translate into durable balance-sheet elasticity rather than episodic forbearance as in Covid.

The big enchilada

Seen in this context, the near-term path of short-term interest rates seems like a second- or even third-order concern. The main objective of the Administration’s hostile takeover of the Fed seems less about interest rates and much more about restoring a system in which private balance sheets intermediate credit and liquidity. It would return the Fed to its traditional role of regulating the economy and inflation by steering market rates through marginal adjustments to its balance sheet rather than being the market’s dominant counterparty. In the process it should expand credit access to SMEs and stimulate the Administration’s broader goals of reindustrialization, redeveloping critical supply chains, and supporting local communities across the country relative to the coastal financial and technology centers.

Broader, more complex implications

If the Administration’s designs on the Fed were limited to lowering frontend interest rates – a consensus view I am wont to differ with – the implications would be straight forward: lower near-term interest rates with an eventual rise in backend term premia as inflation persists and even accelerates. But if it is about the Fed reforms that Administration officials keep talking about, the implications are both broader and more complex.

• The initial bear steepening of the yield curve (rising long-term yields with fixed short-term rates) is likely to be faster than anticipated as markets adjust to the shock of a return to rapid downsizing of the Fed’s stock of Treasury securities.
• If I’m right about the “hawkish pivot,” the bear steepening should evolve into bear flattening over the course of the year as accelerating growth and inflation force a rise in frontend policy rates. If the new Fed chairman is quick to make that pivot, the yield curve itself may pivot with term premia falling as frontend rates rise.
• Regardless, the level of the yield curve will need to rise to accommodate a higher r* – neutral real interest rate – as financial deregulation supports stronger capex demand, particularly by SMEs that had previously been excluded.
• US bank stocks should outperform their international peers – and perhaps the broader US market – as they benefit from greater regulatory forbearance, raising their profitability in any yield curve environment. That said, smaller US banks may initially underperform large US banks as the “institutional” transition at District Reserve Banks likely will take longer than the easing of balance-sheet constraints for large money-center banks whose relief from the liquidity coverage ratio and leverage ratio will be more immediate.
• Industrials and small- and mid-cap stocks may begin to outperform, or at least underperform large-cap tech stocks by less, as the benefits of financial deregulation accrue primarily to them.

Merry Christmas, happy holidays and see you in the new year

This will be my last Seriously, Marvin?! for the year. I’ll return early next year. Unless events or subjects intervene, I’ll next tackle QT’s actual versus perceived effects, what “liquidity” really is, and how a corridor system for policy rates operates versus a floor system. In the meantime, for those of you that celebrate, I wish you a merry Christmas, for others I wish you pleasant holidays, and I wish everyone well in 2026.