Kevin Walsh taking over the Federal Reserve seems almost certain, but JPMorgan poured a bucket of cold water: institutional inertia, stubborn inflation, and a hawkish committee will be stronger forces than the chair.

Written by: Zhao Ying

Source: Wall Street Journal

After the Senate Banking Committee vote, Kevin Walsh has nearly locked in the next chair of the Federal Reserve and might catch up with the June FOMC meeting. However, according to JPMorgan's judgment, Walsh may not quickly lead the Federal Reserve towards interest rate cuts, and the path to balance sheet reduction will also take a long time.

According to Wind Trading Desk, JPMorgan North America economic research analyst Michael Feroli pointed out in the latest report that the Federal Reserve system will constrain Walsh, especially regarding the recent direction of the federal funds rate, making it difficult for the FOMC to cut rates in the short term.

Walsh may come up with several arguments to promote looser policies—AI boosts supply capacity, switching to a trimmed mean inflation indicator, downplaying forward guidance, and reducing the balance sheet. The real topics that could generate good discussion are the balance sheet and communication methods; the policy interest rate is the hardest to move, especially when the FOMC's patience with high inflation is declining, and recently three committee members have leaned towards more hawkish forward guidance.

The report indicates that interest rates require FOMC approval, and balance sheet reduction must first address reserve demand. The press conference appears to be controlled by the chair, but may conversely weaken the chair's ability to shape the narrative. In other words, the Federal Reserve under Walsh will be more like one constrained by institutional factors, inflation data, and internal consensus in the short term.

Interest rate cuts are not simply a matter of changing chairs

Walsh's policy labels are not stable. The report mentioned that he was quite hawkish when serving as a Federal Reserve governor after the financial crisis, but has recently expressed more dovish views on monetary policy, and this shift, whether coincidental or not, is closer to Trump's position.

Even starting from "dovish Walsh," it will be difficult for him to persuade the FOMC to cut rates quickly. The reason is straightforward: the committee's patience with stubborn high inflation is wearing thin, and the recent three dissenting opinions have pointed towards more hawkish forward guidance; additionally, the only reliable dovish member Stephen Miran is leaving, and the vacated seat is the one Walsh is set to fill.

This means Walsh is not simply gaining one vote by taking the chair position but is attempting to push for a directional change within a committee that is not in a hurry to ease policy.

JPMorgan also believes that if Walsh cannot persuade the FOMC, he is unlikely to vote against his own committee. This would be viewed by contemporaneous observers and historians as a signal of failure in the chair’s term. Walsh has previously supported more dissenting opinions, but once he becomes chair, he may reinterpret the value of "collaboration."

AI is unlikely to be an immediate reason for interest rate cuts

One significant reason for Walsh's dovish stance is that AI could enhance the supply-side capabilities of the U.S. economy, thereby reducing inflationary pressures and allowing for lower interest rates, but it is also challenging for the FOMC to accept this.

The report borrowed from Powell's logic during a March press conference: in the short term, generative AI does not immediately expand potential output but leads to the construction of data centers everywhere; this will increase the demand for a series of goods and services, which could marginally push inflation up and raise neutral interest rates in the short term. Over the long term, if AI truly enhances productivity, it could certainly expand potential output, but the key question remains whether demand grows faster than supply. This answer cannot be determined in advance.

This situation is not favorable for Walsh. If he uses AI as a reason for cutting rates, he must contend not only with market narratives but also the FOMC and committee members' skepticism about "when supply shocks will materialize." The report assesses that Powell's views likely reflect those of Federal Reserve staff and the majority of committee members.

Changing the inflation measure might not lead to rate cuts

Walsh has also proposed another path to lower interest rates: re-evaluating how inflation is measured.

The FOMC's official target is 2% PCE inflation, but for a long time, core PCE has typically been used as an intermediate indicator. Walsh believes that trimmed mean inflation could be a better target. This idea currently seems "useful": the trimmed mean inflation rate from the Dallas Fed is now 2.33%, which is 64 basis points lower than core PCE.

However, this measure does not always serve the dovish argument in the same direction. Just at the beginning of 2024, the trimmed mean inflation was still above core inflation. In other words, if Walsh pushes for rate cuts based on the current reading, he can easily be asked: when this indicator was higher, should we have accepted more hawkish conclusions as well?

The report also pointed out that discussing a "new inflation framework" before the Senate Banking Committee is quite different from convincing those who truly study these issues within the FOMC. Chicago Fed President Goolsbee has published peer-reviewed papers on related inflation measurement issues. To promote this path, Walsh will need more specific arguments, rather than just discussing improvements in measurement and observing many prices.

Balancing the reduction talks is easier, but not the main line until 2026

Compared to interest rates, the balance sheet is a field where Walsh is more likely to gain committee responses.

Walsh tends to regulate the macro economy using interest rates rather than the balance sheet. This point sees little controversy within the FOMC. Most Federal Reserve officials have regarded balance sheet policy as an alternative tool when short-term rates are near zero, rather than the preferred tool during normal times.

Walsh also hopes to see a smaller Federal Reserve balance sheet, believing that its current impact on the economy is too significant. The report assesses that many people on the committee may be willing to revisit this issue.

The real constraint lies at the technical level: to reduce the balance sheet without triggering reserve shortages requires lowering banks’ demand for reserves. The Federal Reserve does have several options, but almost all require research and debate, lasting at least months. Therefore, it is believed that this will not become a major policy issue in 2026 or even 2027.

This is also a clear distinction in the report: there may be consensus on the direction of balance sheet reduction, but the path to achieving it will be much slower.

Fewer press conferences may weaken the chair

Walsh has repeatedly addressed communication issues within the Federal Reserve, particularly hoping to reduce forward guidance. His concern is that forward guidance could prematurely lock in policymakers' subsequent choices.

The FOMC would be willing to discuss communication methods again, but it is difficult to form simple conclusions. Just last year, the Federal Reserve conducted a comprehensive review of its communication systems in conjunction with a framework review. Powell's statements this week indicated that the committee was unable to find a broadly supported plan, so it must continue forward. If the dot plot or economic forecast summary is to be modified, it will likely still need a committee vote; moreover, many committee members may want to retain the dot plot because it allows everyone to voice their opinions within the overall communication.

The press conference, on the other hand, belongs more to the chair's authority. This has led to speculation about whether Walsh would cancel press conferences, reduce their frequency, or limit media questioning, but the report suggests he will ultimately maintain the status quo.

The reason is very practical: the press conference allows the chair to be the first to define the policy narrative. If Walsh undermines this setting, the speeches of other Federal Reserve officials might fill the vacuum, potentially diminishing the chair's ability to control the narrative.

The June FOMC will be Walsh's first test. If he personally opposes maintaining the policy but must represent the committee's voice, the press conference will become tricky. In the past, during the terms of Bernanke, Yellen, and Powell, the market believed that the chair was faithfully conveying the committee's consensus; once Walsh's statements are perceived to incorporate personal preferences, the market may become more confused, and the authority of the press conference itself may be undermined.