Warsh says Fed to assess balance sheet changes as inflation eases to 3.5%

Federal Reserve Chairman Kevin Warsh said the central bank will evaluate any adjustments to its balance sheet, opening the door to potential changes in the runoff program as inflation cools but remains above target.

Federal Reserve Chairman Kevin Warsh said Tuesday the central bank will assess any adjustments to its balance sheet, signaling the door is open to changes in the $7.5 trillion portfolio runoff as inflation eased to 3.5% in June. "Any adjustments to the balance sheet will be evaluated," Warsh told the House Financial Services Committee in his first semiannual testimony since taking office May 15, without specifying whether the Fed might slow or accelerate the pace of quantitative tightening.

"The commitment to deliver price stability is strong, unanimous, and unambiguous," Warsh said in prepared remarks. "If we get policy right — and we will — the inflation surge of the last five years will be a thing of the past." The Fed chief has made overhauling central bank communications a hallmark of his early tenure, unveiling five monetary policy task forces addressing the balance sheet, communications, productivity and jobs, data frameworks and inflation.

The June consumer price index fell 0.4% from May, the first monthly decline in six years, driven by a 5.7% drop in energy prices as a fragile ceasefire with Iran eased pressure on gasoline costs. Annual inflation slowed to 3.5% from 4.2%, though core inflation — which strips out food and energy — remained stickier at 2.6%. The S&P 500 rose 0.2% on the data while the tech-heavy Nasdaq added 0.5%, though oil prices resumed their climb with Brent crude gaining 3.3% to $86 a barrel as the US-Iran truce showed signs of fraying.

The balance sheet question comes as the Fed navigates competing pressures. The fed funds rate has been unchanged since the last hike in 2023, and nearly all Fed officials project either holding or raising rates this year, with only one policymaker estimating a cut, according to June projections. Overnight index swap markets currently price no rate move at the July 28-29 meeting, though Fed Governor Christopher Waller said Monday that another "hot reading on core inflation" would force the committee to consider tightening. Warsh has declined to offer forward guidance on rates, saying at his first press conference last month that he does not believe in a "cruel choice" between fighting inflation and supporting employment.

The balance sheet question

The Fed has been shrinking its balance sheet since June 2022, allowing up to $60 billion in Treasury securities and $35 billion in mortgage-backed securities to roll off each month. The pace of runoff has already been slowed once — in June 2024, the Fed reduced the Treasury cap from $60 billion to $25 billion as reserves showed signs of scarcity. Warsh's predecessor, Jerome Powell, had signaled the Fed was nearing the end of quantitative tightening, but Warsh has not committed to a timeline.

Any decision to adjust the runoff program would have direct implications across markets. Slowing the pace of balance sheet reduction would ease upward pressure on longer-term yields, potentially supporting risk assets, while accelerating it could drain liquidity and tighten financial conditions. The 10-year Treasury yield traded near 4.15% Tuesday, down from this year's high of 4.45% in April, as traders weighed the competing forces of cooling inflation and persistent fiscal deficits.

The inflation outlook

Warsh acknowledged that "monthly price fluctuations are inevitable — especially in an unsettled world," a reference to the Middle East conflict that has kept oil prices volatile. Brent crude has surged 18% in July alone as the US-Iran ceasefire collapsed, raising the risk that energy-driven disinflation could reverse. The June CPI report showed that falling gasoline prices accounted for nearly 100% of the monthly decline, making the inflation outlook highly sensitive to geopolitical developments.

"The big risk is still geopolitical," said Jeffrey Roach, chief economist at LPL Financial. "A positive resolution with Iran before the end of the summer is becoming increasingly important." Seema Shah, chief global strategist at Principal Asset Management, said the data "all but rules out a July rate hike" but added that "resurgent energy prices, growing focus on the inflationary effects of the AI capex boom, and Warsh's re-emphasized intolerance for elevated inflation suggest the risk of a rate hike this year is very much alive."

Warsh also highlighted the artificial intelligence investment boom as a structural wild card, describing it as "the most striking feature of the economy right now." He noted that "what is now called 'AI investment' will soon be called just 'investment,'" while cautioning that "new opportunities for the economy introduce new challenges for policymakers."

This article is for informational purposes only and does not constitute investment advice.