With former President Trump nominating Kevin Warsh as the next Federal Reserve Chair, a core policy long advocated by Warsh is drawing intense Wall Street scrutiny: a call for the Fed and the U.S. Treasury Department to forge a new agreement reshaping the relationship between the two powerful institutions. This proposal aims to emulate the historic 1951 accord, with potential repercussions for the $30 trillion U.S. Treasury market and possibly fundamentally altering the Fed's balance sheet management strategies.
According to a Bloomberg report on February 9, although specific details remain undisclosed, Warsh has previously indicated that such an agreement should "clearly and thoughtfully describe" the appropriate size of the Fed's balance sheet and coordinate with the Treasury's debt issuance plans. Concurrently, Treasury Secretary Beth Hammack has also expressed skepticism about the long-term use of quantitative easing (QE), suggesting it should be employed only during genuine emergencies and in coordination with the government.
The report highlights that a key debate among market participants is whether this would constitute merely a bureaucratic fine-tuning or a significant overhaul of the Fed's current securities portfolio, which exceeds $6 trillion. A large-scale adjustment of the asset portfolio could increase volatility in the vast Treasury market and raise profound concerns about central bank independence.
Notably, the U.S. government's annual interest cost on its debt is approximately $1 trillion, fueling speculation that the Fed might assist fiscal financing through some form of "yield curve control," directly impacting inflation expectations and the attractiveness of dollar-denominated assets.
**A Return to 1951? Warsh's Policy Vision** The report notes that during his campaign for the Fed chairmanship, Warsh proposed several policy ideas. Among the most complex yet potentially impactful was his call for a new agreement with the Treasury. Warsh has expressed support for reforming the relationship between the institutions through a new version of the "1951 Accord."
The historic 1951 Accord significantly limited the Fed's footprint in the bond market, established the central bank's autonomy in monetary policy, and ended the Fed's practice, maintained during and after World War II, of capping Treasury yields to keep federal borrowing costs low.
However, Warsh argued last April that the Fed's multi-trillion dollar securities purchases during the global financial crisis and the COVID-19 pandemic effectively violated the principles of the 1951 agreement. In interviews and speeches, he contended that these actions encouraged reckless government borrowing.
Warsh stated in a CNBC interview that a new agreement could clearly define the size of the Fed's balance sheet, while the Treasury would formulate its debt issuance plans accordingly.
**Hammack's Stance and a "Soft Veto"** The report indicates that Treasury Secretary Beth Hammack shares Warsh's critical view of prolonged QE. Hammack has previously criticized the Fed for maintaining QE for too long, arguing it even impaired the market's ability to send crucial financial signals.
As a key figure in selecting the successor to Chair Powell, Hammack advocates that the Fed's QE policies should only be implemented during "true emergencies" and in coordination with other government branches.
Consequently, a potential "streamlined" new agreement might stipulate that, beyond routine liquidity management, the Fed could only engage in large-scale Treasury purchases with Treasury's endorsement and would commit to ending QE as soon as market conditions permit.
However, Krishna Guha of Evercore ISI pointed out that this approach of involving the Treasury in Fed decisions could be interpreted differently. Investors might perceive it as granting Hammack a "soft veto" over any quantitative tightening (QT) plans.
**Portfolio Shift: From Bonds to Bills** Beyond policy framework adjustments, market expectations suggest a more substantive agreement could involve a significant shift in the composition of the Fed's asset holdings: moving from medium and long-term securities towards Treasury bills (T-bills) with maturities of 12 months or less.
Such a shift would allow the Treasury to reduce issuance of notes and bonds, or at least not increase issuance as dramatically as otherwise planned.
In its quarterly debt management statement released last Wednesday, the U.S. Treasury already linked the Fed's actions to its issuance plans, stating it is closely monitoring the central bank's recent increased purchases of T-bills.
Jack McIntyre of Brandywine Global remarked, "We are already on a path of closer coordination between the Fed and the Treasury. The question is whether this coordination will be amplified further."
According to the report, strategists at Deutsche Bank predict that under Warsh's leadership, the Fed could become an active buyer of T-bills over the next five to seven years. In one scenario, they project the share of T-bills in the Fed's holdings could rise from the current less than 5% to 55%.
However, if the Treasury correspondingly shifts towards selling more T-bills instead of interest-bearing securities, it would face the risk of constantly rolling over massive amounts of debt, potentially increasing volatility in the Treasury's borrowing costs.
**Market Risks and Independence Concerns** The report states that while enhanced coordination might aim to lower interest costs for U.S. borrowers, any fundamental shift carries risks. Tim Duy, Chief U.S. Economist at SGH Macro Advisors, warned:
An agreement that explicitly synchronizes the Fed's balance sheet with Treasury financing, directly linking monetary operations to the deficit, resembles a yield curve control framework more than it insulates the Fed.
Ed Al-Hussainy, a portfolio manager at Columbia Threadneedle Investments, was more blunt, stating that if an agreement implied the Treasury could count on the Fed buying a portion of the debt or specific parts of the yield curve for the foreseeable future, "that would be incredibly, incredibly problematic."
In a worst-case scenario, investors might perceive the Fed's actions as deviating from its inflation-fighting mandate, thereby pushing up volatility and inflation expectations, and potentially undermining the dollar's appeal and U.S. Treasuries' safe-haven status.
**Skepticism Regarding a Formal Agreement** Beyond the Treasury market, some experts propose broader scenarios. Evercore ISI's Guha suggested the idea of the Fed swapping its $2 trillion portfolio of mortgage-backed securities (MBS) with the Treasury for T-bills.
While facing numerous obstacles, one potential goal could be to lower mortgage rates, an area of focus for the Trump administration. Former Fed Vice Chair Clarida, now at Pimco, also wrote that a new agreement might provide a framework for the Fed, Treasury, and even housing agencies like Fannie Mae and Freddie Mac to work together to reduce the size of the balance sheet.
However, Mark Dowding, Chief Investment Officer at RBC BlueBay Asset Management, believes Warsh would likely strive to preserve Fed independence. "This doesn't rule out enhanced cooperation, but it makes a formal agreement less likely."
Brandeis University economics professor George Hall cautioned that direct coordination to suppress interest costs "might work for a while," but in the long run, investors have alternatives to U.S. assets.
"People will figure out ways around this, and over time, they will move their money elsewhere."
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